---- by Steve Whitehouse ----
PARIS (AFX) - The European Central Bank will raise interest rates at some stage soon, but it is likely to hold off from tightening policy at today's governing council meeting, economists said. While the inflation outlook has clearly deteriorated, which would call for an early rate increase, the ECB will not want to crush the still fragile economic recovery by raising rates too quickly, they said.
The recent appreciation of the euro also relieves pressure for an early rate rise, they added. "It is a finely balanced call whether the ECB tightens on June 6 or waits longer. The ECB has left its options open but we believe it will wait until July or perhaps even later," said Guillaume Menuet of 4CAST.
"With the euro area recovery still in its early stages, the governing council debate will likely come down on the side of a reluctance to risk constraining the pace of the rebound," he said. Beat Schumacher of Credit Suisse agreed that the ECB faces a dilemma.
"All in all the ECB is in a tricky situation and it is very difficult to make a forecast. Our main scenario is still a first rate hike of 25 basis points in September/October but the probability of a earlier move has increased significantly," he said.
In a survey of 35 economists last week by AFX News and Agence France-Presse, 32 said they expect the minimum bid rate on ECB refinancing operations to be kept at 3.25 pct at today's meeting.
But most of those surveyed -- 21 of the 35 -- said they expect the ECB to tighten policy at some stage in the third quarter, with many focussing on the July 4 meeting in Luxembourg as the most likely timing for the rate move.
ECB president Wim Duisenberg may use the news conference following this week's meeting to prepare the ground for a tightening move at a subsequent council meeting, they said.
Expectations of a rate hike have been growing since the last ECB news conference on May 2, when Duisenberg signalled a shift in the council's assessment of inflation risks.
Euro zone inflation has been slower to decline than the ECB previously expected, and although it eased to a provisional 2.0 pct in May, any further falls are likely to be limited and average inflation for the year will be at or above the ECB's 2 pct price stability ceiling, economists said.
Meanwhile, risks for future inflation have increased on a number of fronts, they said. "The key factors are of course the higher inflation profile... the sustained price of oil, the disappointing outcome of wage negotiations in the euro area, and the high level of liquidity in the economy," said GianLuigi Mandruzzato of IntesaBci.
Although the ECB currently gives little weight to M3 money supply growth, this remains stubbornly high and may become an increasing cause for concern if it fails to decelerate as previously predicted by the central bank. M3 growth rose to 7.5 pct year-on-year in April from 7.3 pct in March, well above the ECB's 4.5 pct reference value.
And the ECB has voiced concern about wage developments, which will undoubtedly be on the agenda of this week's meeting following the 4 pct increase negotiated by the IG Metall union in Germany.
Taken together, these factors have resulted in a rise in inflation expectations, with the ECB's latest survey of professional forecasters pointing to euro zone annual average inflation of 2.1 pct this year, revised up from 1.7 pct previously. The forecast for 2003 inflation was also raised to to 1.9 pct from 1.8 pct.
"Inflation expectations are a key factor determining ECB thinking," said Joachim Fels and Elga Bartsch of Morgan Stanley. In addition to the upward revision in economists' inflation forecasts, there are worrying signs from the bond market, with the so-called breakeven inflation rate derived from yields on French inflation-linked bonds above 2 pct since late March, they said. Given all of the concerns about inflation, and the shift in the ECB's rhetoric, some economists see no reason for the central bank to wait any longer before hiking rates.
"In our minds, the case is there and it was made by the ECB in May, so there doesn't seem a reason to delay," said Kelly Tonkin of Lehman Brothers, who is forecasting a 50 basis point hike this week.
Fels and Bartsch said that the earlier the ECB moves to quell inflation expectations, the less it will ultimately need to tighten. But there are also reasons for holding off from an immediate rate hike.
"The inflation rate will come down in coming months slightly (due to positive base effects), the euro has firmed slightly and the economic rebound is still at the beginning and weak," said Schumacher of Credit Suisse. And Claudia Henke of Dresdner Bank said Duisenberg's recent hawkish tone may have had more to do with a need to reinforce the ECB's anti-inflation credentials than with preparing the ground for an imminent rate hike. "The increased hawkishness on the part of the ECB was partly prompted by increasing speculation that the bank will fail to meet its medium-term goal of keeping EMU inflation below 2 pct for the third year in a row.
"It was important for the ECB's credibility to respond verbally, in other words to use communication as an instrument of monetary policy. However, an interest rate hike seems unlikely before the end of the summer break," she said.
After the July 4 meeting in Luxembourg, the governing council will next consider its monetary policy stance at an Aug 1 meeting in Frankfurt, before taking a summer break. The next rate-setting meeting after that is on Sept 12.
The euro's recent appreciation has also given the ECB additional breathing space before it needs to raise rates, because a strengthening euro weighs on import prices.
"The euro is rising, and that should enable the ECB to wait until September," said Philippe Weber of CPR.
And waiting for a while might be exactly what the euro zone economy needs, with the recovery still in its very early stages. Euro zone GDP grew just 0.2 pct quarter-on-quarter in the first quarter, after a decline of 0.3 pct in the fourth quarter. The first quarter growth figure equated to an annualised growth rate of 0.8 pct compared with 5.6 pct in the US, economists noted. "The Euroland economic recovery remains fragile. If the ECB raises rates too sharply and too quickly, this could nip the current rebound in the bud," said Marc Touati of Natexis Banques Populaires.
Weber said that although inflation remains stubbornly high, the best advanced indicator for future inflation is economic activity, which is still weak, and the ECB should take account of this.
Laure Maillard of Caisse des Depots said the central bank will probably only raise rates once there are strong signs of recovery, with growth around its 2.0-2.5 pct potential annualised rate and the labour market stabilising.
Michael Schubert of Commerzbank agreed that the ECB is likely to give particular weight to economic growth in the timing of its rate hike. On inflation grounds alone, the ECB should be looking to raise rates quickly to a neutral level, which he said is around 4 pct.
But he added: "The ECB will probably try to delay the first rate hike for as long as possible, since in its view the growth prospects for the euro area remain uncertain."