The ECB has been the most hawkish of the major central banks so far this year, but maybe not for much longer.

Yesterday ECB President Trichet hinted at a more dovish approach during testimony to the EU. He said that risks to the medium-term outlook for price developments are under study and will be updated at the next ECB meeting on 8th September when the next staff projections are released. This may suggest inflation expectations will be revised lower as the growth outlook has deteriorated.

Although Trichet said that inflation in the euro area has remained elevated for some months, he added this was mainly driven by commodity prices. Brent crude oil is lower than its $126 per barrel peak in April, however, it currently remains elevated above $112 per barrel. The ECB will be watching developments at the Fed closely, if the US central bank announces more QE later this year, this could spark a rally in commodities (as it did during QE2), which would keep upward pressure on inflation in the euro area.

The hawkish stance of the ECB has been one of the factors supporting the euro, especially against the pound and the dollar. If the ECB shifts to a more dovish position then the euro may suffer against the majors in the medium-term as its loses its yield differential.

However, we don't expect a sharp reverse-turn in the ECB's thinking. It tends to be the most hawkish of the major central banks and is renowned for not tolerating inflation pressure. As we mentioned above there are still some upside risks to commodity prices so the ECB won't want to rush into a more dovish stance too quickly.

It's last staff projections for the euro area released in June 2011 stated:

  •  The current monetary stance is still accommodative
  •  Inflation is expected to remain above 2% for the rest of 2011
  •  The average inflation rate is expected to be between 2.5% and 2.7% in 2011 and 1.1% and 2.3% in 2012.

Back in June, the expectation was for domestic price pressures to rise (wages etc) as commodity prices fell, however, if growth continues to slow then tight labour market conditions may not materialise, reducing domestic price pressures going forward and weighing on the overall inflation rate.

Any changes to the 2012 outlook for inflation may move the market as investors try to price in the prospect of a more dovish ECB. However, we don't think that ECB will cut rates any time soon as this would 1, damage their credibility 2, there is no urgent need to cut rates since real interest rates (adjusted for inflation) remain negative.

We think instead the ECB will acknowledge the downside risks to their inflation forecast but will adopt a more cautious wait-and-see approach rather than an outright shift to a dovish stance at its September meeting.

Going forward the data points worth watching includes German wage growth, which has been rising at a faster clip than it has in the UK and US, along with inflation expectations as these are good indicators of domestic price pressure.

The chart below shows Eurozone inflation expectations (white line) and EURUSD, as you can see these two move together closely (weekly chart)

Chart source: Bloomberg

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Kathleen Brooks| Research Director UK EMEA |

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