09/07/2011 08:15 pm ET Updated Nov 07, 2011

ECB to signal change in policy tack as crisis bites

By Paul Carrel

FRANKFURT (Reuters) - The European Central Bank is expected to signal a change in policy direction on Thursday, halting an interest-rate rise cycle just five months after it started as the euro zone debt crisis weighs on the economy.

New inflation and growth forecasts from the ECB's in-house economists are likely to be revised down from the last round in June, allowing the bank's policymakers to justify a halt to the tightening cycle they began without other leading central banks.

While inflation remained at 2.5 percent last month, well above the ECB target of just below 2 percent zone, such is the concern about faltering growth that financial markets are pricing in a cut to rates from 1.5 percent as early as December.

Economists, who tend to take a broader view than that shown in market pricing, see an outside chance the ECB could cut in the months ahead, though such a U-turn after hikes in April and July would embarrass ECB President Jean-Claude Trichet, who is unlikely to back a cut before his term ends next month.

"It's not out of the question but it's highly unlikely," said Berenberg bank economist Holger Schmieding. "It would probably take a major recession ... to change the ECB's mind on rates, and I don't think we are anywhere close to that."

A month after the ECB reactivated its controversial bond-buying program, markets will also be looking for signs of how the central bank plans to deploy the measure, which it is using to hold down government borrowing costs in Italy and Spain.

The ECB is concerned that by buying the sovereign bonds of Italy -- the euro zone's third largest economy -- it is only encouraging the Italian government to slacken efforts to shore up its finances, doing little to tackle to roots of the crisis.

By allowing market borrowing costs to rise, the ECB can raise pressure on Italy to implement austerity measures.

Italy responded to a renewed attack on its bonds by promising on Tuesday to hike value-added tax. The pledge came after Italian bond yields crept up to around 5.5 percent, above the 5 percent level the ECB had appeared to be targeting.

Mario Draghi, who will succeed Trichet from November 1, warned euro zone governments earlier this week they should not assume the bond purchases would continue indefinitely.

"I think the ECB's view is that the program is temporary, but it makes no sense to be shouting about it, it makes sense to be a bit opaque and just say the program is ongoing," said Nick Kounis, an economist at ABN Amro.

Societe Generale economist James Nixon said the rise in Italian bonds yields above 5 percent raised questions about the ECB's commitment to the program. He expected the central bank to keep the heat on Italy to implement budget-saving measures.

"There will be a fairly strong message from the ECB for the need for credible steps in austerity," Nixon said.


Policymakers' failure to resolve the debt crisis has eroded confidence in the 17-country euro zone, slowing the economy.

The euro zone's dominant service sector was effectively stagnant last month after two years of growth and manufacturing activity, which drove a large part of the economic recovery in the bloc, shrank for the first time since September 2009.

Some private sector economists put the chance of a return to recession at least 50 percent. Against this backdrop, the vast majority of forecasters polled by Reuters expected the ECB to revise down its 2011 and 2012 GDP projections from the respective 1.5-2.3 and 0.6-2.8 percent announced in June.

Economists were fairly evenly split as to whether the central bank would revise down or leave unchanged its 2011 and 2012 inflation forecasts. Only three of 46 saw an upward revision.

They will pay close attention to the language Trichet uses at his 1230 GMT news conference to assess inflation risks. Last month, he said there were "upside risks to price stability."

"I imagine they will no longer say that inflation risks are on the upside. My own view is that they have moved to the downside, but I don't think the ECB will move that quickly. The first step they will make is to say that they are balanced," said ABN Amro's Kounis.

"It's interesting whether they go for downside risks to growth forecast, that would give a bit of a hint that they are willing to consider rate cuts in the future," he added.

Last month, Trichet said risks to the economic outlook for the euro area "remain broadly balanced."

(Additional reporting by Sakari Suoninen, editing by Mike Peacock)