ECB Watch: The future might look rosy but rate rises loom
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ECB Watch: The future might look rosy but rate rises loom

Alongside the announcement that it was raising its key interest rates by 25 basis points last month, the European Central Bank released the latest set of growth and inflation forecasts prepared jointly by the staff of the ECB and the euro area national central banks. ECB president Jean-Claude Trichet is always at pains to emphasize that these “projections” – which are shown as ranges, rather than point estimates, to reflect the uncertainties associated with past forecasting errors – are published on the responsibility of the staff and are not formally endorsed by the ECB’s executive board or its governing council.

They do, however, constitute one of the key inputs to the ECB’s monetary policy deliberations and they tend to form the basis of the governing council’s “baseline scenario” for where it believes the euro area economy is heading.

The latest projections (see chart), which incorporate upward revisions to the previously projected growth rates for 2006 and 2007 and are broadly in line with forecasts by the European Commission and other international bodies, show real GDP growth remaining quite buoyant at above 2% per annum in 2007 and 2008, albeit less vigorous than in 2006. Given that publicly the ECB sees the eurozone’s potential (non-inflationary) growth rate as being towards the lower end of a 2% to 2.5% range, this might suggest that demand pressures will no longer be building up. This in turn would be consistent with the projected slowing of inflation to a rate in 2008 that meets the ECB’s definition of price stability: “below, but close to, 2%”. Surely then, the ECB will see no need for further rate rises this year.

Alas, not so, for a number of reasons. First, in making the projections, the staff have factored in an assumption, based on forward money market rates, that three-month rates will average 4% in 2007, which would imply an average over the year of more than 3.75%

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