FRANKFURT, Jan 8 - The European Central Bank is widely expected to keep euro zone interest rates unchanged on Thursday, confident that the economic recovery is strong enough to bear the burden of the soaring euro for now. Policy makers so far have not sounded worried about the rallying euro, which has gained some six percent versus the dollar from the beginning of December, pressuring inflation and giving the central bank time before possibly tightening policy. But the ECB may find itself in a bind if the euro rises further and causes problems for the export-dependent economy, analysts say. Businesses are already complaining the currency's strength is making it harder to sell their products abroad. "For the time being it is not a major, major problem because... there is lots of compensation by the stronger than anticipated global recovery which is helping exports along," said Christa Aranda-Hassel, economist at CSFB in London. "But if the strength continues, and we start breaking pain thresholds for the industry... the clear risk is that we'll have a recovery which is export-led (but) stops in its tracks before having spilt over to domestic demand," she added.
Governing Council members made no comment when entering the ECB's headquarters for the meeting, which has now started. Further euro gains might enable the ECB to wait longer before it raises its benchmark refinancing rate from a 2.00 percent record low -- most economists in a poll said it would wait to do so until the second half of this year anyway. Financial markets have also eased their aggressive bets on a quick rate hike and are now pricing in only a 40 percent chance of a quarter point rate hike by the end of June. Some economists are even saying rates will come down again. "It is of the kind of magnitude which I believe puts a rate cut firmly on the agenda already at this stage, though I wouldn't describe a probability higher than one in three for this meeting," said Klaus Baader from Lehman Brothers. Belgium, a country that depends on exports of consumer and intermediate goods, urged the ECB to ease its policy stance if the euro rose further.
EURO MUDDLES ECB PICTURE
Assuming a euro level of $1.17 -- a level which the single currency has already exceeded by more than eight percent -- the ECB painted a picture in December of a gradually recovering economy and dwindling inflation. But the stronger-than-expected currency means both growth and inflation may pan out lower than expected and the 12 nation single currency bloc may not get close to its cruising speed towards the end of 2004 as now predicted. And the euro's bull run may not be over yet. It briefly peaked above a new record high of $1.28 on Tuesday and most currency strategists think it will touch or top the key $1.30 level later this year. Many say such levels will not be short-lived, but may be sustained during much of the year. On a trade-weighted basis, the ECB's relevant policy gauge, the euro has gained a considerable five percent since November. Portuguese central bank Vitor Constancio sounded upbeat on the euro zone economy this week, saying he expected that the bloc had already got close to its two to 2.5 percent potential output growth rate in the fourth quarter of last year. But euro zone economic sentiment dropped in December, EU data showed this week, casting doubt over that rosy outlook. Moreover, the euro zone's service sector slowed its pace in December, the Euro Zone Services survey showed, even though growth remained strong and a similar survey showed the manufacturing sector picked up speed. Most of all, domestic demand is still slack, as consumers worry about jobs. German retail sales fell sharply in November, making it likely private consumption would again prove to have been a drag on Europe's largest economy in the fourth quarter. Small wonder then, that companies are complaining about currency strength. German carmaker DaimlerChrysler said there could be a major impact on earnings at its Mercedes-Benz luxury unit if the euro stayed strong into 2005.
BUT IT HELPS INFLATION
The bright side of the euro storming the charts is that it helps inflation, which at 2.1 percent in December is still hovering above the central bank's two percent tolerance ceiling. Just as the strong currency puts a lid on growth, it also helps inflation down as it deflates oil and other import prices down while at the same time giving exporters less to spend.//