Despite economic contraction in the second quarter, the European Central Bank (ECB) yesterday (Thursday) maintained its hawkish stance on inflation.

Led by President Jean-Claude Trichet, the ECB’s monetary policy committee voted to hold interest rates steady at 4.25%.

“Upside risks to price stability prevail,” Trichet said at a press conference in Frankfurt after voting to keep the rate at its seven-year high, Bloomberg News reported. “We’re resolute in our determination to keep inflation expectations in line with price stability.”

In July, the ECB increased its key interest rate by 25 basis points to its current level from 4.0% in hopes of curtailing second-round inflation effects.

But the Eurozone economy, which covers the 15 nations that share the euro currency, contracted 0.2% in the second quarter, according to Eurostat. And due to weakening in the Eurozone economy and a faltering euro that is at a seven-month low versus the dollar, many traders and investors had hoped for an easing of rates. 

“Upon leaving rates at 4.25 percent this Thursday, the ECB will probably refute market hopes for a rate cut in the near future,” Bank of America Corp. (BAC) Economist Holger Schmieding said in a research note.

The ECB also revised its outlook for economic growth down, moving its forecast for 2008 to 1.4% from 1.8% and its forecast for 2009 to 1.2% from 1.5%.

Still, while inflation has begun to moderate, it is still at 3.8%, well above the ECB’s target rate of 2.0%. And Trichet firmly believes combating inflation must be the central bank’s top priority.

“There is particularly a very strong concern that the emergence of broad-based second-round effects in price and wage-setting behavior could add significantly to inflationary pressures,” Trichet said at the press conference. The ECB is watching current wage talks with several labor unions “with particular attention.”

The Bank of England (BOE) also voted yesterday to hold interest rates steady.

News and Related Story Links:

• Bloomberg News:
• Trichet Focused on Inflation Even as Growth Slows

• Forbes:
  With Rates On Hold, Europe Peers Through Gloom

• The Associated Press:
  ECB, Bank of England keep interest rates unchanged

• Money Morning:
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After boosting its benchmark interest rate by a quarter point on July 3, the European Central Bank (ECB) may be forced to reverse course and cut rates sooner than it planned, as slow growth is beginning to trump concerns about inflation.

The ECB left its key rate unchanged at 4.25% yesterday (Thursday). ECB President Jean-Claude Trichet said that while growth will be "particularly weak" in the second and third quarters, inflation is also "likely to remain well above levels consistent with price stability for a protracted period of time."

"Risks to price stability over the medium term remain on the upside," he added, noting that recent data "underpinned" the bank’s decision to raise rates last month.

However, don’t anticipate the ECB will have the wiggle room to raise rates any higher, as more and more data suggests the European Union is entering a recession.

An unexpected drop in Germany’s factory orders for June was the latest blow to the Eurozone’s economic outlook. Orders fell 2.9% in June, after a 1.4% decline in May, leading economists to speculate that economic growth in Europe’s largest economy is contracting.

The German economy contracted by 1% in the second quarter, and Eurozone growth may was flat at best, economists at BNP Paribas SA (OTC: BNPQY) said in a research note.

"In light of the imploding order flow, the July ECB rate hike looks increasingly like a policy mistake in need of being urgently reversed," MarketWatch quoted the note as saying. 

However, it could be awhile before the ECB changes its direction. Inflation remains at a 16-year high after consumer prices soared 4.1% in July. And according to Trichet, "there are some indications that labor-cost growth has been rising in recent quarters."

Negotiated wages in Germany were up 3.5% in the year through April, the biggest gain in 12 years, according to Bloomberg News. In Italy, wage inflation jumped to 3.6% in June.

Inflation risks "remain clearly on the upside and have increased over the past few months," Trichet said. "There is very strong concern that price and wage-setting behavior could add to inflationary pressure."

It’s possible the ECB may start cutting rates in early 2009, if not late this year. However, economists aren’t holding their breath.

"They are a bit of an oil tanker. They don’t change course very rapidly," Russell Jones, head of fixed income and currency strategy research at RBC Capital Markets Corp., told MarketWatch.

Another analysts, Matthew Sharratt, an economist at Bank of America in London (BAC), told Bloomberg that "they’restill focused on high inflation, but the best way to avoid a policy mistake would be to keep interest rates on hold."

News and Related Story Links:

• MarketWatch:
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• Bloomberg:
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• European Central Bank:
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• Money Morning:
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By Jennifer Yousfi
Managing Editor

After voting to hold rates steady at its monthly meeting yesterday (Thursday), European Central Bank (ECB) President Jean-Claude Trichet said a rate hike in July is “possible.”

Inflation in the Eurozone is running at a 16-year high.  And on Wednesday, the Organisation for Economic Cooperation and Development (OECD) boosted its inflation prediction to 3.4% in 2008, well above the ECB’s 2% target.

Policymakers voted to keep the central bank’s key interest rate at 4.0%. The ECB also held its two other key rates – the deposit rate and the marginal lending rate – unchanged at 3.0% and 5.0% respectively, the AFP reported.

“The ECB is trapped,” Joerg Kraemer, chief economist at Commerzbank AG (OTC: CRZBY) in Frankfurt, told Bloomberg News. “We have the problem of persistently high inflation rates, while growth is weakening. I expect them to keep rates on hold for a very long time.”

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But with prices for food and fuel soaring across the Eurozone, merely holding rates steady might not be enough for the hawkish ECB.

A rate increase next month “is not excluded,” Trichet said, but “is not certain,” adding that the ECB never “precommits” to a move and that the policymakers would only make a final decision on the day they meet.

Separately, the Bank of England also voted to hold its key interest rate steady at 5.0%.

“Inflation is painfully high and the negative effect on purchasing power is squeezing the life out of the [Eurozone] economy,” Ken Wattret, an economist at BNP Paribas SA in London told Bloomberg. “It now looks increasingly like a consumer recession is unfolding.”

Economic growth is slowing, as even Germany, the European Union’s largest economy, has experienced some softening and an up-tick in unemployment. The OECD revised its growth projection down to just 1.7 % this year and to 1.4% in 2009, AFP reported.

Contrasting Currency Effects

Europe’s central banks have clearly made inflation their priority, a stark contrast to the U.S. Federal Reserve’s aggressive rate-cutting campaign. The Fed has slashed 325 basis points from the key Fed Funds rate since mid-September. The key U.S. interest rate now stands at just 2.0%, well below that of its European counterpart, putting more pressure on an already weak greenback.

Comments from Fed Chairman Ben S. Bernanke on Tuesday acknowledged the weakening effect the U.S. rate cuts have had on the dollar.

Speaking via satellite at the International Monetary Conference in Barcelona, Spain, Bernanke said the Fed is working with the Treasury to “carefully monitor developments in foreign exchange markets.” The Fed Chair said he was aware the effect of the dollar’s decline on inflation and price expectations, Bloomberg News reported.

It is widely expected that the Federal Open Market Committee (FOMC) will vote to remain on pause at its next meeting scheduled for June 24 – 25.

Bernanke’s comments gave a slight boost to the dollar, only to be reversed by Trichet’s allusion to a possibly ECB rate hike in June.

The dollar lost ground against the euro to trade at $1.559 in mid-morning trading today, up from $1.547 at the New York close the day of Bernanke’s remarks.

News and Related Story Links:

• MarketWatch:
  July euro-zone rate hike called possible

• Bloomberg News:
  ECB Leaves Benchmark Rate at Six-Year High to Fight Inflation

• AFP:
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• Money Morning:
  Fed Chair Comments Boost Greenback

• Money Morning:
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The European Central Bank indicated it may still raise interest rates in September and announced another three month loan – this one $54 billion – to ease lending between commercial banks during the ongoing credit crunch, Bloomberg News reported.

The ECB has injected emergency funds into the global financial system over the past two weeks after the U.S. subprime-mortgage crisis spread to Europe and then made commercial banks more reluctant to lend to each other.

Yesterday, the Frankfurt-based ECB responded to speculation that it may hold off raising interest rates on Sept. 6 by saying it’s sticking to the policy stance stated by President Jean-Claude Trichet on Aug. 2. At the time, Trichet pledged to show "strong vigilance” on inflation, a phrase he has used to signal each of the eight rate increases since late 2005.

“The ECB signaled that it still sees the current market turbulence as a financial market event rather than a grave risk to the overall economic outlook,” Holger Schmieding, chief European economist at Bank of America Corp. in London, told Bloomberg in an interview. “The ECB has thus chosen to stick to its September rate plans unless market turbulence gets out of hand.”

The credit mess that started as a slowdown in the U.S. housing industry, and then spread to the sub-prime mortgage market, morphed into a full-blown global credit crisis yesterday (Thursday), forcing the European Central Bank into action.

Yesterday’s developments were no surprise to us, for we’ve been saying for months that the fallout from the housing-market meltdown was going to balloon into a worldwide financial problem [Click here to read our recent news report on this topic: Never Trust an Investor With a Microscope].

And the financial tsunami seemed as if it traversed the globe yesterday.

In its biggest plunge since it underwent a 416-point dead drop on Feb. 27, the Dow Jones Industrial Average yesterday plunged 387 points, or 2.8%, to close at 13,271. For the closely watched blue-chip index, it was the sixth-largest single-day point loss since the closing portion of 1999. And it was also the 11th time in the past 15 trading sessions that the 30-stock Dow posted a daily change of more than 100 points – a sign that the burgeoning credit crisis has caused volatility to spike.

The scorching decline was touched off after the European Central Bank yesterday (Thursday) loaned more than $130 billion to banks at a rate of 4%, intending it as a cash infusion to assuage a credit crunch brought on by the collapse of the U.S. sub-prime-mortgage market. The ECB stated that this was the largest amount ever dispensed in a single “fine-tuning” operation, exceeding the $95 billion given out on Sept. 12, 2001, the day after the terror attacks on New York.

In recent weeks, it was clear that the credit problems were spreading to other markets worldwide: A hedge fund collapsed in Australia, and sub-prime losses stung a bank in Germany .

The ECB has now stepped in where U.S. Federal Reserve Chairman Ben S. Bernanke and the U.S. central bank couldn’t or didn’t. The ECB, which is responsible for the monetary policy of 13 nations in and around Europe, allocated the funds to ensure orderly market conditions. [For some perspective on the ECB’s action, click here to check out what our resident global trading expert and newest team member had to say].

Yesterday’s problem first began when the largest bank in France, BNP Paribas SA, halted withdrawals from three asset-backed funds linked to U.S. sub-prime mortgages.  It was a move eerily reminiscent of those made by The U.S.-based Bear Stearns Cos. (NYSE: BSC) . As a result, stocks in both the U.S. and U.K. markets plunged, and the overnight rates banks charge each other to lend in dollars soared to a six-year high. At that point the ECB was prompted to mobilize.

The U.S. Federal Reserve added $24 billion in temporary reserves to the banking system yesterday, the most since April. Federal Reserve policymakers met Tuesday to discuss the outlook of the U.S. economy, but afterward announced that inflation – and not the credit crunch – remained its primary concern.  The ECB decision should not be immediately interpreted as the right decision however. An effort to prop up a market could backfire and actually perpetuate a lack in investor confidence.

European stocks were badly blistered, too. Britain’s FTSE 100 index closed down 1.9% yesterday, dropping 122 points. Germany’s DAX index fell 2%. And France’s CAC-40 index – down more than 3% at one point – closed down nearly 2.2%.

Asian shares were mixed. Hong Kong’s Hang Seng index dropped 0.43%. Japan’s Nikkei index rose 0.83%.

The happenings abroad surely played their part, but just as devastating to the Dow was a report from AIG that mortgage defaults are spreading from the sub-prime to the prime sector of real estate.