NO RATE CHANGE LIKELY THURSDAY: INFLATION WORRIES, BUT WEAK DEMAND AND COST PRESSURES: RATES ON HOLD TO END 2005/EARLY 2006

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1 . ECB Observer EZA 658/02Feb05: ECB Council Preview February 2005 NO RATE CHANGE LIKELY THURSDAY: INFLATION WORRIES, BUT WEAK DEMAND AND COST PRESSURES: RATES ON HOLD TO END 2005/EARLY 2006 Again no change in interest rates likely at next Governing Council meeting. Latest data suggest balance of debate tilting back slightly towards inflation concerns, reinforced by continuing strong money growth but... demand and cost pressures remain subdued and inflation expectations ease. More hawkish tone from Trichet likely but... expect rates to stay on hold, barring US$ crash/oil hike, until growth rate returns close to trend - late 2005 or early OVERALL ASSESSMENT 1. In recent issues of ECB Observer (see EZA Report Nos. 646/30Nov04, 648/06Dec04, 651/04Jan05 and 652/11Jan05) we have argued that the balance of debate within the ECB Governing Council has been shifting away from immediate inflationary concerns, but not to the extent that a cut in interest rates would be a serious proposition. Now we see the see-saw tilting back slightly towards potential inflation worries a little further ahead, with current inflation running higher and monetary pressures continuing to build, but not yet to a degree that an early rise in interest rates has become more likely. While the ECB may be moved to shift the characterisation of its policy stance back again from 'continued vigilance' to 'strong vigilance', we remain of the view that interest rates will remain on hold at least until the fourth quarter of 2005, and probably into the first months of Over the past month the picture regarding cost and price pressures has become somewhat more cloudy. Both the 'headline' rate of inflation and 'core' inflation on the ECB's preferred definition are now shown to have increased in December by 0.2 percentage points, to 2.4% and 2.1% respectively, despite a softening of energy prices and favourable year- ago base effects. This adverse movement, however, is largely explained by what may prove to be one-off effects and the likelihood remains that, after January, inflation will be seen to be subsiding in successive months. 3. In the meantime, no significant secondround inflation effects appear to be taking hold. Recent rises in producer prices have been modest, labour costs remain well contained and inflation expectations (as measured by break-even rates for indexed bonds) which had appeared to be creeping higher since the summer of 2004 have more recently eased back. With lagged effects of the past appreciation of the exchange likely still to be feeding through, the rather softer tone of the euro over the past month should not have significant inflationary implications. 4. On all the evidence so far, demand and output in the eurozone have continued to stagnate. Industrial production fell for the second month in succession in November and retail sales were flat and survey-based indicators suggest that economic sentiment and business confidence remained hesitant around the turn of the year. Only industrial new orders, bouncing back in November after a slight fall the 1

2 previous month, give a hint of better things to come. 5. Meanwhile, evidence from the monetary analysis provides increasing cause for concern. The rates of growth of M3 and private sector lending have accelerated further and the liquidity overhang has gone on growing. For many months now the ECB has been pointing to the potential threat this poses to price stability over the medium term, if the economic recovery were to strengthen. In our view, however, the ECB will not take action on this account until it has accumulated firm evidence that economic growth had returned to trend. 6. With demand subdued, and cost pressures and inflation expectations contained, the Governing Council is most unlikely to find a consensus in favour of an interest rate rise this week, in spite the latest disappointing inflation numbers and growing concern about the behaviour of the monetary aggregates. The ECB is likely to remain unshaken in its belief that inflation and growth will 'come good' in the coming months, in line with the ECB/Eurosystem staffs' December macroeconomic projections. 7. We therefore expect there to be no change in the policy stance but rather more hawkish language to be used in the President's prepared statement to the Press on Thursday. Furthermore, with inflation set to subside and economic activity recovering slowly, we re-main of the view that interest rates will stay on hold for several more quarters until, perhaps in the early part of 2006, there is sufficient evidence that growth has returned to trend. 8. In this, we remain somewhat out of kilter with the positioning of most financial market participants and analysts. The Euribor futures market is now pricing in a rate increase of 25 basis points by early autumn a little further out than indicated a month ago - with a further 25 bp rise towards the end of the first quarter of percentage points above cash Euribor Changes in 3-month Euribor rates priced into futures market late October 2004 late November 2004 late December 2004 late January Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 3-month Euribor Futures Contract Similarly, while none of the 24 market economists participating in FT Deutschland's latest monthly interest rate survey expects an increase in interest rates this month or even by April, 18 of them are expecting rates to have risen by an average of 50 basis points by February 2006, with one (CSFB) seeing a 100 basis point rise. 2

3 The Economic Analysis Costs and prices 9. The MUICP 'headline' rate of inflation, which had dropped back to 2.2% in November from 2.4% in October, is now provisionally shown to have reverted to 2.4% in December, despite relatively favourable year-ago base effects and the easing of energy prices towards the end of The Governing Council will see this as disappointing - especially given Eurostat's 'flash' estimate of 2.3% for December, which had been available last time - but not altogether surprising: the ECB has been pointing out for some time that inflation rates of above 2% were likely to persist for some months, before falling below 2% later this year. percentage change on year ago 'Headline' Inflation (MUICP) 'Core' Inflation* ECB's "price stability" range (1.7%-1.9%) Eurozone Inflation Rate * MUICP excluding unprocessed food and energy 10. Equally disappointing is the latest infor mation about 'core' inflation which, on the ECB's preferred measure (the annual rate of increase in the MUICP excluding energy and unprocessed food), accelerated from 1.9% in November to 2.1% in December. It should however be noted that the bulk of the increase in the full index and in this sub-set, between November and December, is attributable to the higher cost of package holidays - which may reflect a lagged (and possibly short-lived) response to earlier oil price rises - and to tobacco taxes. Percentage points Base effects on monthly changes in 'headline' inflation rate (n.s.a) Mar-04 Latest monthly change in HICP Year-ago monthly change in HICP (inverted) Latest month's change in 'headline' inflation rate Sep The Governing Council may continue to find some reassurance in the fact that there are as yet no very clear signs that continuing high oil (and other commodity) prices are leading to more deep-rooted second-round inflation effects. The latest data on industrial producer prices at the time of their last meeting showed the total index to have fallen by 0.2% in November, on the back of a 1.2% fall in energy prices, to stand 3.6% higher than a year ago, compared with 4.0% in October. Excluding energy, producer prices rose by a very modest 0.1% in November, to a level 2.6% higher Percentage change on year earlier Industrial Producer Prices Total Industry Total excl. Energy Energy 3

4 than a year earlier. Nevertheless, the ECB will be scrutinising very closely the producer price data for December which are due to be published this Wednesday, 2 February. 12. Also providing some reassurance are medium-term inflation expectations which (as measured by break-even inflation rates for MUICP-linked indexed government bonds) had seemed to be creeping upwards again since the summer but have generally eased back slightly in the past two months. per cent per annum Medium-term Inflation Expectations: Break-even inflation rates OAT 2009 (French link) BTPei 2008 OATei 2012 BTPei Recently revised data on the rise in total hourly labour costs confirm the previously available picture of muted domestic cost pressures. Having accelerated between 2003 Q4 and 2004 Q1 from 2.2% to 3.2% in industry and from 2.3% to 2.8% in the economy as a whole, the annual rate of increase in hourly labour costs then subsided to 2.4% and 2.2% respectively in 2004 Q2 and to 1.9% (revised up from 1.8%) and 1.9% (revised down from %) respectively in 2004 Q This subdued development of labour costs clearly reflects the muted nature of the economic recovery and the continuing high level of unemployment, as well as modest structural labour market reforms in several eurozone countries. According to Eurostat's latest, revised, data the unemployment rate has been hovering between 8.8% and 8.9% since the beginning of 2004, most recently rising from 8.8% in November to 8.9% in December. percentage change on year ago Q4 Mar Q2 1999Q4 Sep Q2 Mar-03 Sep-03 Total Hourly Labour Costs 2000Q4 2001Q2 2001Q4 2002Q2 2002Q4 Mar-04 Industry 2003Q2 Whole Economy 2003Q4 Sep Q2 2004Q4 Mar Political pressure (at best counterproduc tive) on the ECB to cut interest rates, in response to euro strength and the weakness of the economic recovery, should have lessened recently. During January, the nominal effective exchange rate of the euro softened appreciably, being on average 1.1% lower than in December. As a result, the effective exchange rate was only 0.9 % higher in January than a year earlier and only 6.0% higher than at the beginning of EMU. While this will diminish somewhat the attenuating effect on import costs (and also the dampening of net external demand), the ECB can be expected to argue that the beneficial effects on inflation of the longer-run appreciation of the euro - which in Index (1999 Q1 = 100) Jan-02 Apr-02 Euro EER EER (28-day movg. avge.) USD per EUR GBP per EUR External value of the euro Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan

5 effective terms is still 10.6% higher than in January should still be feeding through. Output, demand and confidence 16. The Governing Council will not have any new information about real GDP growth. Revised data already available at their last meeting confirmed Eurostat's previous estimate that real GDP increased by 0.3% in Upward revisions to both exports and imports resulted in an unchanged contribution (-0.7 percentage points) of net trade to GDP growth. With the contribution of government consumption shaded down, from 0.2 pp to 0.1 pp, that of fixed investment revised up slightly, from 0.1 pp to 0.2 pp, and contributions from stockbuilding and private consumption unchanged, at 0.7 pp and 0.1 pp, the total contribution of domestic demand to GDP growth was essentially unchanged at %. Eurostat's 'flash' estimate of GDP growth in 2004 Q4 will not be published until 15 February. Percentage points Q3 Contributions to Quarterly GDP Growth Net External Trade Households Cons. Expend. Gov. Consum. Expend Stockbuilding Gross Fixed Invest. Real GDP (RHS) Domestic Demand 2003-Q Q Q Q Q/Q-1 pecentage change 17. Also available to the Governing Council a month ago was the latest release of the European Commission's indicator-based forecast of quarterly GDP growth, which again predicted growth of 0.4% (+/- 0.2%) in 2004 Q4 but revised upwards the prediction for 2005 Q1 from 0.4% (+/- 0.2%) to 0.5% (+/- 0.2%). 18. The latest data on industrial production do not lend support to these modestly optimistic predictions. Having recovered by 0.7% (revised from 0.8%) in September, production is now estimated to have fallen back again by 0.6% (revised from -0.5%) in October and by a further 0.3% in November to a level only 0.5%% higher than in November On average over the three months September- November as a whole, industrial output was actually 0.1% lower than in the previous three months. 19. More encouraging is the latest informa tion on industrial new orders which, following a surge of 1.6% (revised from 1.7%) in September and a slight fall (-0.2%, revised from +0.2%) in October, bounced back by 1.7% in November to a level 12.2% higher than a year earlier. On average over the three months to November the new order volume Index (Year 2000= 100) Index (Year 2000 = 100) Euro Zone Industrial Production Industrial Output (LHS) Industrial New Orders % change latest 3 mths on prev. 3 (RHS) New Orders s.a. Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 3-month moving average % change latest 3 on previous 3 months

6 was 1.4% higher than in the three months June-August. 20. The Governing Council will have no new information about the volume of retail trade which, according to the latest available data, has remained stagnant. Having fallen by 0.1% in September and recovered 0.4% (revised down from 0.7%) in October, retail sales were flat in November at a level only 0.4% higher than a year ago. Taking the latest three months together, sales volumes were 0.2% down on the previous three months. Data for December will only become available the day after the Governing Council meets. Index (Year 2000 = 100) Volume of Retail Trade Volume of Retail Trade 3-mth movg. avge. (centered) 21. The European Commission's latest survey-based confidence indicators do not point to a more vigorous eurozone economy at the beginning of The Economic Sentiment Indicator, which had dropped by 0.6% in November and by a further 0.7% in December, regained only 0.4% in January. A rebound in confidence in the services sector and a slight improvement in the retail trade sector more than offset slight declines in industry and construction confidence, while consumer confidence, already weak, was unchanged. Index (long-term average = 100) Eurozone Confidence Indicators Economic Sentiment Indicator (LHS) Business Climate Indicator (RHS) points of standard deviation 22. At the same time, the Business Climate Indicator, which had crept 5 points higher in December 2004, dropped back 4 points in January 2005, as weaker views about production expectations, stocks of finished products and recent past production trends outweighed modest improvements in views about export and total order book trends. The Monetary Analysis 23. Latest monetary data confirm that the Growth of M3 and Bank Loans to Private Sector upward trend in the annual rate of M3 growth M3 Growth 11 witnessed from the end of the second quarter M3 Growth (3-month average) 10 of 2004 is now firmly established. Having 9 ECB Reference Value (4.5%) eased from 6.0% in September to 5.8% in October it has now accelerated for three months 8 7 in succession to reach 6.4% in December, almost 2 pp above the ECB's 4.5% medium- 5 6 term reference value. What is more, the threemonth average of the annual growth rates of 3 4 M3, to which the ECB pays particular attention, has continued to edge higher, from 6.0% 6 per cent change on year ago Growth of bank loans to non-bank private sector

7 (revised up from 5.9%) in September- November to 6.1% in October-December. 24. Of the main components of M3, the annual rate of growth of M1 slowed from 9.8% in November to 8.4% in December but the rate of accumulation of term deposits and the growth of marketable instruments both accelerated, from 3.2% to 4.5% and from 2.9% to 6.3% respectively. 25. Among the asset counterparts of M3, the annual rate of growth of loans to the nonbank private sector, which has been accelerating since August, increased further to 7.0% in December, from 6.9% in November, fuelled by continuing rapid growth in consumer credit and lending for house purchase and buoyant medium- to long-term lending to non-financial corporations. This should portend a strengthening of domestic demand but also fuel ECB fears that monetary growth poses a potential threat to price stability over the medium term. On the other hand, the annual growth rate of credit extended to general government has slowed significantly since last summer, from 6.6% in August to 2.4% in December. 26. The continuing rapid growth in broad money is reflected in our latest monthly estimates of the liquidity over-hang in the eurozone. The M3 Money Gap, which has been widening every month since May, widened significantly further in both nominal and real terms in December, when the monthly growth of M3 was almost double the monthly rate of increase implied by the ECB's 4.5% pa Reference Value while the monthly rate of increase in the MUICP was slightly less than the monthly rate implied by the ECB's definition of price stability. per cent of M3 stock (Dec = 0) Nominal and Real Money Gaps Nominal M3 Gap Real M3 Gap John Arrowsmith +44 (0) arrowsmith@ezadvisors.com Eurozone Advisors Ltd, 2 February2005 This research is confidential and intended solely for the named person or entity to whom it is addressed. If you have received this in error you are not permitted to disseminate, copy or take any action in reliance on it, and are requested to please notify the sender by return or telephone. No part may be reproduced or passed on without permission. Neither the information nor the opinions herein constitute or are to be construed as an offer or solicitation of an offer to buy or sell investments. EZA information is based on sources believed reliable. Their accuracy cannot however be fully guaranteed. 7

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