ECB rate plan comes as confidence slumps

By Gabi Thesing  |   2008-6-24  |     NEWSPAPER EDITION

EUROPE'S manufacturing and services industries unexpectedly shrank and German business confidence slumped in June, increasing concern that the European Central Bank's plan to raise interest rates next month will hurt economic growth.

Royal Bank of Scotland Group Plc's composite index fell to 49.5 from May's 51.1 yesterday, the first time it dropped below 50 in five years. A reading under 50 indicates contraction.

The Munich-based Ifo institute said its business climate index, based on a survey of 7,000 executives, declined to 101.3 from 103.5. That's the lowest since January 2006, Bloomberg News reported.

"The ECB is taking an unprecedented risk with euro-area growth by raising rates," said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland in London. "The data clearly show that growth will be weaker than the bank expects and are historically consistent with the ECB cutting interest rates."

The ECB has said it may raise its benchmark rate by a quarter percent next month to 4.25 percent to contain inflation. Policy makers are split on whether one step will be enough to keep a lid on prices, which have accelerated at the fastest pace in 16 years after oil and food prices rose to a record.

"The data is not enough to deter the ECB from raising rates in July," said Juergen Michels, an economist at Citigroup Inc in London. "However, it strengthens the hands of the council members more concerned about growth."

Investors have pushed back expectations for a second interest rate increase to December from October, Eonia forward contracts showed. The majority of investors still forecast inflation concerns will force the bank to lift borrowing costs for a third time in March.

ECB executive board member Lorenzo Bini Smaghi said last week one step should be "enough" to bring inflation back to the ECB's goal of just below 2 percent and that rising oil prices will leave their "mark in the second half of the year."

By contrast, his fellow board member, Juergen Stark, said he expects a "gradual recovery as soon as the second half of the year." Cypriot council member Athanasios Orphanides said he "cannot rule out" that further interest rate increases may be necessary after July. Policy makers say the region's economic fundamentals are sound and inflation remains their main concern.

The euro-area economy will expand about 1.8 percent this year and 1.5 percent in 2009, according to ECB forecasts. Prices rose 3.7 percent from a year earlier last month. The ECB forecasts that inflation will average 3.4 percent this year and 2.4 percent in 2009.

The price of oil has doubled over the past year to a record US$139.89 a barrel on last Monday, boosting companies' costs and eroding consumer's purchasing power.

Volkswagen AG, Europe's largest auto maker, said sales of VW-brand cars declined last month as higher fuel prices discouraged buyers.

"The high oil price has all the characteristics of a shock," said Gerd Hassel, an economist at BHF Bank in Frankfurt. "Companies are right to expect harder times." Adding to pressure on companies is the euro's 15-percent increase against the dollar in the past 12 months, which makes exports less competitive outside the currency region.

Some companies are coping with the economic downturn, helped by expansion in Asia and Eastern Europe and by raising prices.

MAN AG, Europe's third-largest truck maker, on June 4 stuck with its full-year targets, saying growth in Poland and Russia is offsetting slowing economies elsewhere.