Overview: We anticipate that the ECB will cut the leading policy rate by 50 bp at the meeting on 15 January. Anything less would be a disappointment and nothing more than postponing the inevitable. We project they will lower rates to 1.5% before the end of Q1 2009. Euroland is already firmly in recession and the recent indicators have been very weak pointing to the deepest recession for decades. Business and consumer confidence has collapsed and industrial production is in free fall. Furthermore, upside risk to price stability has disappeared completely and the ECB has plenty of firepower left. This should provide a perfect basis for the ECB to cut rates aggressively on Thursday. The ECB may, however, disappoint. They have already cut the leading rate at an unprecedented pace totalling 175 bp since October 8; and they have mentioned that these cuts at the moment, are far from having been fully transmitted to the economy. Furthermore, the next meeting is in just three weeks, by which time they will have much more information. If they hesitate on Thursday, we would expect them to send a clear signal of a (significant) policy easing in February.

Policy bias: The tone at the press conference depends heavily on the rate decision on Thursday. Given our baseline scenario, we expect the tone to be soft, stressing that the economy is weak and that risks to price stability at the policy-relevant horizon are more balanced than in the past. They will, however, be careful not to sound too pessimistic in order to avoid signalling that the ECB has a more pessimistic assessment of the economy than market participants. If they - in some variant - reintroduce their usual key policy phrase On the basis of our assessment, the current monetary policy stance will contribute to achieving our objective it is a signal that they will be sidelined at the meeting on February 5. Should they disappoint, we expect them to signal clearly that there is scope for a (significant) policy rate reduction at the February meeting (then they will have much more information on e.g. fiscal policy inside and outside the euro area and surveys such as those of bank loan officers and professional forecasters).

Growth: The economy is already firmly in recession, and at the last meeting the ECB - for the first time ever - forecast a contraction on a one year horizon. Since then most indicators have been very depressing. The Commission's business climate index, which points to the phase of the business cycle, dropped sharply to -3.17 points - the lowest since records started in 1985 - from -2.10 in November, pointing to a steep and deep recession. Manufacturing PMI tumbled to a new record low of 33.9 from 36.2 and services PMI fell to 42.1 from 42.5 in November. We have seen some stabilisation in the German Ifo expectations index, declining only slightly to 76.8 from 77.6. It thereby is at the lowest since 1973 just before the deep recession in 1974/75. The depressing outlook is backed by harder data such as industrial production, which has dropped 7% y/y in Germany, 9% y/y in France and 15% in Spain. German exports suffered a record drop in November, down 10.6% vs October. German manufacturing orders plunged 6% m/m in November; down approximately 25% y/y. Unemployment rose to 7.8% in November and household unemployment expectations surged to 55 points from 44 in November, coming close to an all-time high of 60 set in 1993.

Accordingly, a sizeable downward revision of the ECB December Staff projection for growth is on the cards. Mr Trichet will likely mention that the economic outlook remains surrounded by an exceptionally high degree of uncertaintyand, that risks to economic growth lie on the downside.

Inflation: Inflation is declining rapidly. According to the December Flash estimate, inflation plunged to 1.6% from 2.1% y/y in November and 3.2% y/y in October mainly on the back of the dive in commodity prices. If sustained, the low commodity prices will drive inflation down until mid 2009. Then inflation should bottom out around 0% y/y, the precise outcome depending heavily on the path for commodity prices. The composite PMI price index for both input and output prices fell to record low levels. Producer price increases for consumption goods once again declined markedly to 1.9% y/y in November from 2.6% y/y in October. Usually core inflation lags producer prices by approximately 9 months. Thus, even though core inflation may pick up slightly over the coming months (as producers - if they have any pricing power left - may try to pass on incurred cost from historical high commodity prices), it would surely only be a short lived increase.

The main worry left is the increase in total labour costs in Q3 2008 to 4.0% y/y from 2.8% in Q2 and 3.5% in Q1. At the same time negotiated wages rose to 3.4% from 2.8% y/y in Q2. This reflects largely the usual lagged effects from a relatively tight labour market. Furthermore, consumer inflation expectations have declined rapidly (down to 7.4 index points from 10.5, also well below the since-2002 average of 21.3) and the outlook for employment has deteriorated markedly. This should bring wage increases down and help ease worries related to the negotiated wage statistics..

Monetary developments: M3 growth and credit growth has slowed further to 7.8% y/y from 8.7% y/y but the data does not look like a credit crunch. Still, M3 is growth is way above the 4½% reference rate. Growth in private sector loans declined further to 7.1% y/y from 7.8% y/y. Loans to non-financial corporations slowed to 11.1% y/y from 11.9% y/y. Consumer loans for housing decelerated markedly from 3.5% y/y to 2.5% y/y while consumer credit slowed from 3.4% y/y to 2.8% y/y and consumer loans for other purposes faded slightly to 1.9% y/y from 2.3% y/y.
Selected comments made by members of the ECB Council since the meeting last month

Jean-Claude Trichet (President), January 7

Solid anchoring (of inflation expectations), ... also contributes to protect against the possible threat of deflation, which is not the case at present. ... It's clear that we have had a significant deterioration of the real economy... What strikes me is that the most recent projections are also the most pessimistic.

Vitor Constancio (Portugal), January 6

Any risk of inflation consolidating far below this value (2 %) should be contained preemptively with interest rate reductions, ... At this moment it (monetary policy) is particularly limited in its possibilities of transmission due to the lack of confidence and liquidity in various parts of the credit and monetary markets.

Jean-Claude Trichet (President), December 30

We have already cut rates by 175 basis points within a very short span of time. This impulse is, at the moment, far from having been fully transmitted to the economy.

Ewald Nowotny (Austria), December 30

There are positive and negative signals, and one must therefore respond very quickly if needed. Lucas Papademos (Vice-president), December 28

As regards the future, risks to price stability seem to be balanced but may show a downward trend. If this projection is confirmed, then further loosening of monetary policy is advisable.

Miguel Angel Fernandez Ordonez (Spain), December 21

We will decide (on interest rates) in January. If, among other variables, we see that inflation expectations are much lower than 2 percent, it's logical that we would lower rates.

Axel Weber (Germany), December 17

I wouldn't cry wolf if, in a situation of very low inflation and positive real rates, nominal rates would briefly fall below 2 percent. ... We've highlighted downside risks to growth, and news out since our latest projections indicate that some of those risks have started to materialise.

Yves Mersch (Luxembourg), December 12

We have to preserve the effectiveness of monetary policy. ... That means also the effectiveness of the instrument that we use, the short term policy rate.

Axel Weber (Germany), December 11

We should be careful when our interest rates enter into territory never explored before. Our lowest level so far was 2 %.