Central Bank Forecasts: ECB Remains on Hold Through 2012

After rate hikes in April and July (each by +25 bps), ECB's main refinancing rate is now at 1.5%. We expect the central bank will remain on hold through 2012 given weakened growth and inflation outlook. Recent macroeconomic data have been disappointing. Eurozone's GDP growth eased to +0.2% q/q in 2Q11 from +0.8% in the prior quarter. Germany's economy expanded only +0.1% q/q while growth in France stalled. Manufacturing activities have shown signs of fatigue with manufacturing PMI slipping to 49.7 in August from 50.4 a month ago. while consumer confidence soured as there's no way out for the sovereign debt crisis. ZEW's survey showed that Eurozone's economic sentiment tumbled to -40 in August from -7 a month ago. The market had expected a pickup to -6.2. The index for Germany alone plunged to -37.6 from -15.1. Fiscal consolidative measures in debt-ridden economies will also weigh on growth. Diminishing inflationary pressures due to global economy downturn and easing commodity prices also make the central bank more comfortable in putting interest rates on hold. Tight fiscal and accommodative monetary stances will be the region's policy mix in coming years.

We currently expect Eurozone's GDP to grow +1.8% in 2011 before slowing to +1% in 2012. On annual basis, economic growth was as strong as +2.5% in 1Q11 but then deteriorated to +1.7% in 2Q11. Given the weaker prospect In global economic activities, the 17-nation region's exports will be hurt in the second half of the year. Together with domestic issues such as fiscal tightening and loss in consumer confidence which would result in shrinking household spending, Eurozone's outlook will be significantly weaker in the second half than the first half. Indeed, risks to our growth forecasts are skewed to the downside. Indeed, Both Morgan Stanley and Deutsche Bank trimmed their estimates to +1.7% for 2011 and +0.5% for 2012 last week.

Inflation moderated to +2.5% in July from +2.7% in June but remained above ECB's target of 'below, but close to, 2%'. High energy and food remained the key upward price pressures. In the second half of the year, inflationary pressures may ease as domestic demand weakens. Moreover, geopolitical turmoil in Libya is about to come to an end. This would resume the country's oil supply and alleviate the pressure coming from oil prices.

While we expect the ECB will keep interest rates low given moderating inflationary pressures and sovereign debt problems in the European periphery, it has few measures left to stimulate economic growth. The central bank may adopt rate cuts of -50 bps, thus return the policy rate to the unprecedented level of 1%. As far as non-standard measures are concerned, full allotments of LTROs and MROs remained in place. The ECB announced at the August meeting, Full allotment of fixed rate MROs will be continued for 'as long as necessary'.

President Trichet also signaled at the press conference that the Securities Market Program (SMP) has been re-activated. According to the latest report, the settled 14.29B euro in purchases of government bonds in SMP in the week ended August 19. This compared with the purchase of 22B euro in the prior week when the program was 'resumed' to stabilize Spanish and Italian bond yields. The ECB said it will drain 110.5B euro from the market at its weekly auction of one-week deposits. We expect the program will continue even after the EFSF has started operation. Given the small size of the EFSF, it may have limited capability to intervene through secondary purchases.