ECB will wait and see

Data released since the previous publication of Weekly Focus generally indicate that Europe is heading for a slowdown - a slowdown that could become a recession if business confidence continues to slide (see Euroland: Surveys smell of recession). Annualised inflation, meanwhile, does not appear set to ease anytime soon, as the recent fall in the price of oil will take some time to feed through. June saw consumer prices rise by 4% y/y, and the first estimates of the July number indicate an increase to 4.1 % y/y. We expect that in-flation will hit a peak of 4.2% y/y in the course of Q3.

The main event of the coming week will undoubtedly be Thursday's rate decision from the ECB. Like the market, we expect that the ECB will keep interest rates unchanged at 4.25%, after hiking by 25bp at its July meeting on fears of second-round effects on inflation. The ECB now expects that inflation will not moderate towards the central bank's target rate of 2% until 2009.

As we wrote in Global: Inflation expectations monitor, both consumer and market implied inflation expecta-tions are rising in most of Europe. On top of this comes a fear that administered prices will be raised due to the recent increases in commodity prices. This is putting pressure on the ECB to hike rates. That said, help is perhaps at hand in the shape of the commodity market losing some steam - oil prices are down $24 from $145/bbl at the start of July, and food prices too have begun to ease. Nor can the ECB have failed to notice the past month's weakness in business confidence, which would again ease the pressure to hike.

We do not expect the ECB to alter its rhetoric from the July meeting. Instead it will wait and see if inflation will start to retreat on the back of the slide in commodity prices. However, a nod in the direction of the weak growth data could be on the cards. Speeches by members of the ECB have been thin on the ground of late, but those that have been given have generally expressed satisfaction with the current level of interest rates. This is also reflected in the markets' expectations, with just a 33% probability of a rate hike before the end of the year priced in.

Key events of the week ahead

• Thursday's rate decision is event of the week.
• German trade figures on Thursday will reveal if ex-ports are still under pressure.
• Italian GDP is scheduled for Friday, and might give some indication for the direction of Euroland GDP.