FRANKFURT, May 27 - European Central Bank Vice President Lucas Papademos said euro zone inflation would trend downwards into 2004 even as a gradual recovery picks up pace. In a guarded reading of the euro zone, Papademos stopped short of saying the improving inflation outlook gives the central bank some leeway to cut interest rates. "I will not elaborate on possible changes in our policy stance," Papademos told the Frankfurt international finance journalists' club on Monday in remarks embargoed for release on Tuesday.
Still, he did provide arguments for why the ECB may choose easier credit, including the euro's strength, which will dampen foreign demand. The comments by Papademos and other ECB policymakers in recent days have bolstered financial market expectations that the ECB will trim borrowing costs at its policy meeting next week, said Rainer Guntermann, an economist at DKW in Frankfurt. "The debate is whether it will be a quarter-point or a half-point cut," he said. A 50-basis point cut is justified but might give the unwanted signal to the markets that the ECB is concerned about deflation, or falling prices, he added.
The June Euribor futures contract was indicating short-term interest rates at 2.18 percent. The ECB's benchmark interest rate now stands at 2.50 percent. Guntermann said the euro's rise provided a strong fundamental argument for a half-point cut in borrowing costs. Papademos said the euro's appreciation against other currencies will help curb price rises. The annual inflation rate in the 12-nation euro area was likely to hover around two percent until the end of 2003 and decline markedly thereafter.
"We expect inflation to fall clearly below two percent next year and to stabilise there," he said. The surge in the euro, which hit a record level above $1.19 on Tuesday, and moderating oil prices are helping dampen inflationary pressures. "Recent developments seem to confirm the favourable trend toward price stability will continue into next year," he said. Preliminary euro zone consumer price data for April showed inflation slowing to 2.1 percent from 2.4 percent in March.
GROWTH WEAK
Papademos painted a picture of tepid growth prospects. For one, the euro's surge to record highs might bring the currency back to historical averages, but it will force economic growth to come more from domestic sources than foreign demand, he said. Euro zone growth was likely to be very subdued in the first half, but he repeated the ECB's forecast for moderate recovery later this year that would gather pace in 2004. Despite the gloom at the start of this year which has led some economists to trim their 2003 euro zone growth forecasts, Papademos said the ECB would be ill-advised to follow suit. "Recent developments may suggest actual growth may be marginally below one percent. On the other hand, the first signs of recovery may also be in the pipeline," he said.
"It's not prudent to try to adjust the projections of one percent in a downward way...we would like to see more information and assess it before coming to conclusions." There were still risks that growth could be dampened by economic imbalances outside the euro area, the potential spread of the SARS virus, consumer uncertainty and the changes European companies were making to restore profits and productivity. But he gave no signal that the euro had strengthened excessively, rather the currency has to be seen in the context of its previous weakness. Its current level was now close to its calculated average over the last 15 years. "The euro at present levels does reflect economic fundamentals," he said.
LITTLE DEFLATION RISK
Papademos said the ECB would take action to head off the threat of deflation if it were to appear, but the risk of falling prices in both the euro area and in its individual members, such as Germany, was small. "Deflation is more undesirable than an inflation rate above two percent," he said. "Appropriate measures will be taken to insure deflation risks do not materialise."
DKW's Guntermann said ECB comments by Papademos and others playing down deflation risks might be a means of defusing market concerns ahead of a 50 basis point cut. "Maybe they have already started to intervene verbally against this (deflation risk) interpretation. They need to cut by 50 basis points," he said.//