Overview : We expect the ECB to hold the leading policy rate unchanged at 2% at the meeting on 5 February. At the last meeting, Trichet signalled very clearly that the next important meeting is in March. In the Q&A session he said Let me add that we consider that our next important meeting for monetary policy will be ... in March, when we will have substantial new information at our disposal and our new projections. Given that our decision-making meeting in February is only three weeks away, we do not deem it an important meeting for policy-making. The next important meeting will be in March. Furthermore, the ECB mentioned that the decision to lower rates in January did entail a further weakening of the economy.

Thus the ECB clearly wishes to drag its heels over further aggressive easing. We expect this to be reflected in a broadly neutral statement on Thursday. Despite this, we project it will lower rates to 1.5% before the end of Q1 09. The economy simply looks so weak the ECB cannot avoid going below 2%. Euroland is already firmly in recession and even though we have had a small rebound in business sentiment, indicators still point to the deepest recession for decades. Also, upside risk to price stability has disappeared completely and the ECB has plenty of firepower left. In addition, comments made by members of the Council increasingly indicate that it is willing to go below 2%. At the meeting in March, it will have a new set of projections which will form a perfect basis for the ECB to cut rates aggressively.

Policy bias : The tone at the press conference will most likely be quite neutral. On the one hand the tone will be soft stressing that the economy is weak and reiterating that it considers risks to price stability over the medium term to be broadly balanced. On the other hand it will mention that it has already lowered the policy rate 225bp in total, demonstrating that it has done a lot already. It will repeat that at the meeting in January it was taking into account a significant further alleviation of inflationary risks, owing in particular, but not exclusively, to the slowdown of the global and European economies.

The ECB will refrain from commenting with any precision on questions on quantitative measures.

Growth: Since the meeting in January some signs of a stabilisation of the situation have emerged. The PMI recovered slightly in January from record-low readings for the 10-year-old survey. Manufacturing PMI increased 0.5 index points to 34.4 while the index for services companies edged up from 42.1 to 42.2 in January. Though still at a very low level, the German Ifo climate index edged up to 83.0 from 82.7 in December driven by a strong rebound in the expectations index to 79.4 from 76.9. French firms' business confidence remained stuck at a record low in January. The Commission's business climate index, which points to the phase of the business cycle, eased to -3.16 points in January from -3.09 in December (upward revision from -3.16), marking the lowest since records started in January 1985. The Commission survey - which is a relatively precise but somewhat lagging indicator - showed that economic sentiment deteriorated markedly in January to 68.9 from 70.4 (revised from 67.1) and is now at the lowest since records began in 1985. The deterioration was broadly based with the strongest decline in the services sector, which generates more than two-thirds of the eurozone's gross domestic product. It set a record low of -22, from -17 in December. Sentiment in industry hit a new low of -34 against -33 in December, and optimism among consumers declined to a record low of -31 from -30.

Only a few harder data have been released, most prominently Euroland unemployment which rose to 8.0% of the workforce in December

A sizeable downward revision of the ECB December staff projection for growth is on the cards. Mr. Trichet is likely to mention that the economic outlook remains surrounded by an exceptionally high degree of uncertainty and, that risks to economic growth remain clearly on the downside.

Inflation : The rapid decline in Euroland inflation continued in January. According to the January flash estimate, inflation plunged to 1.1% from 1.6% in December and is now at the lowest for nearly 10 years and well below the ECB's target of just under 2%. Base effects from the low commodity prices is the main driver but also - we suspect - as a result of companies' fading pricing power due to a combination of low demand, the need to liquidate soaring stocks and rising credit costs. If sustained, the low commodity prices will drive inflation down until mid-2009. Then inflation bottoms out around 0% y/y - the precise outcome depending heavily on the path for commodity prices. Our projection is backed by the most recent data which indicate that price pressure is easing further. Composite PMI price index for both input and output prices fell further in January from record-low levels. The whole economy input price PMI crept down to 43.8 from 44.4, while output price PMI declined to 43.7 from 45.3. Producer price increases for consumption goods once again declined markedly to 1.5% y/y in December from 2.0% y/y. Usually core inflation lags producer prices by approximately nine months. Thus, even though core inflation may pick up slightly over the coming months as producers may - if they have any pricing power left - pass on incurred costs from past high commodity prices, it will surely only be a short-lived and moderate spike.

Consumer inflation expectations have declined rapidly (down to 5.2 index points from 7.4, well below the 2002 average of 21.3 and close to the record low 2.5 reading in April 2004). Two-year breakeven inflation rates - the difference between yields on inflation-protected bonds and conventional bonds - suggest inflation rates below 0.5% two years out.

Monetary developments : Annual M3 growth slowed in December to 7.3% y/y from 7.7% y/y in November. This compares to the peak in November 2007 of 12.3% y/y. Private loan growth slowed significantly, from 7.1% in November to 5.8% in December, in part reflecting the sharp decline in production but perhaps also the first sign of a tightening of credits. The slowdown was led by a significant decline in non-financial corporation loans from 11.1% to 9.4%. Also, growth in all types of consumer loans eased.

Since the unlimited provision of liquidity began by mid-October liquidity has been so abundant (at the policy rate) that the eonia has persistently traded well below the main policy rate. Recently, the eonia rate has collapsed to close to the deposit rate at 1.0%, which from the ECB's perspective constitutes a floor to the overnight rate (eonia). This large discrepancy contrasts with the conduct of the ECB's monetary operations in more normal times (eonia has historically traded slightly above the main policy rate) and in effect it represents an easing of monetary policy. Another implication is that it currently is very difficult to assess market expectations on changes in the ECB's leading rate.

Selected comments made by members of the ECB Council since the meeting last month

Mario Draghi (Italy), February 2

On the monetary front, I think the response by central banks (to the financial crisis) has been prompt and massive, and has certainly been very effective. But it's clear that now there isn't much room left to go to have lower interest rates.

Jean-Claude Trichet (President), January 29

We are at 2 percent and I didn't exclude we could go below 2.

Athanasios Orphanides (Cyprus), January 29

A central bank with a policy rate that is positive but rather low might be incorrectly advised to 'save its ammunition' so that it may still be in a position to ease policy later on. ... The idea of such policy (rates at zero) ineffectiveness is a fallacy. ... It may be desirable for central banks to take forceful and pre-emptive interest rate action aiming to minimise the probability that they may later find themselves in a situation where they will be forced to resort to unconventional policy easing.

Guy Quaden (Belgium), January 27

We are probably ready to cut further.

Ewald Nowotny (Austria), January 27

The goal of the ECB is inflation not more than but also close to 2 percent... We are very actively fighting inflation but also very actively fighting deflation. ... The lesson we all have to learn is: avoid excess money, avoid too low long-term interest rates because this means you are inducing unsustainable structures that in the end create a bubble.

Axel Weber (Germany), January 26

We do not see a danger of deflation in the medium term for the euro zone.

Yves Mersch (Luxembourg), January 26

The margin for manoeuvre is rapidly diminishing, especially after the latest cut.

Jose Manuel Gonzalez-Paramo (Executive Board), January 26

To go below the historic minimum must be justified by exceptional reasons. And what doubt is there that there is something exceptional in the events we have in front of us.

Gertrude Tumpel-Gugerell (Executive Board), January 22

We are aware that the crisis is far from over, we are aware that the effects on the real economy have only started to be felt and we also are aware that there are substantial differences between euro area countries.