ECB change of rate view

We have found it necessary to make a downward revision to the eurozone growth and interest rate forecasts for 2008. At the end of last year, we envisaged a marked slowing of eurozone GDP growth to 1.6 per cent in 2008 and maintained our long-held view that the ECB would resort to cutting interest rates in the second quarter, once the worst of inflation was over and the pace of economic activity had moved undisputedly below trend. Initially we only expected one rate cut from the ECB this year, but to hit our 2009 forecast of 1.6 per cent we now expect more rate reductions from the ECB by early 2009.

The reasons for edging down our growth forecasts slightly further are three-fold: the disappointingly weak recent eurozone consumer spending data; the tightening in banks' lending conditions combined with their expectation of falling corporate loan demand, and the deteriorating external environment.

We have not altered our expected timing of the ECB's first rate cut. Over the next couple of months the need to talk down inflation expectations during this critical period of (primarily German) wage negotiations at a time when inflation remains above three per cent will dominate.

We still do not see a cut until the second quarter of this year (with May the most likely month) and possibly a further one or two rate cuts, however we do not expect these cuts to be delivered particularly quickly.

The ECB appears to be of the view that rates in the eurozone barely got to neutral in the latest tightening cycle. While few believe the ECB's threat that it could still raise rates, it will be much less aggressive in its easing policy than either the Fed or BoE.

We envisage a scenario whereby Eurozone growth remains clearly sub-trend with quarterly growth rates of about 0.3 per cent quarter-on-quarter or less through most of 2008 and a gradual easing of inflation to a little below two per cent by end-year, which will allow the ECB to gradually lower its policy rate to 3.25 per cent by the turn of the year.

Here's a look at other important European currencies:

Swedish krona: The Riksbank suggests that the key interest rate may need to be increased further some time this year, as pipeline inflationary pressures persist. This year's growth inflation mix is expected to take a turn for the worse with the Riksbank expecting core inflationary pressures at 2.4 per cent compared to 2.2 per cent previously and growth at 2.4 per cent from 2.8 per cent. The Riksbank hopes that only one more rate hike is needed to bring inflation closer to target.

We are looking for a SEK recovery this year. This is hinged on the idea that the SEK is no longer a funding currency and Sweden's privatisation programme will bring continued M&A inflows. The SEK has recently recovered some lost ground versus the euro, but a more sustainable rally by the SEK also requires improved equity market sentiment.

Norwegian kroner: The Norges Bank kept its key rate steady at 5.25 per cent in January and provided little forward-looking guidance. In the previous statements, the central bank would suggest interest rates need to be increased further but the latest statement kept a tight lid on what to expect going forward. The Norges Bank may be more comfortable that its target rate may be nearing an appropriate level given rising inflationary pressures.

However, the deteriorating external outlook is likely to be an overriding source of concern and should therefore help keep interest rates steady for some time.

When comparing target rates, the NOK is moving closer to being formally defined as a G10 high yielding currency. GBP is expected to leave this group as the Bank of England cuts rates. We think the switch in the pecking order of high yielding currencies should continue to push the NOK higher.

Swiss franc: The CHF has continued to strengthen as market nervousness has not abated. Although the CHF should appreciate as investors look to find a safe haven, we did not expect it to have performed quite so well, given that the ongoing turmoil is largely based in financial markets, on which Switzerland is reliant. However, it managed to push to record highs against the US dollar at the start of February, and this may continue for the time being.

Members of the Swiss National Bank, including President Roth, have maintained that the appreciation of the currency has been beneficial in fighting inflation, and their worries that CHF weakness would increase upward price pressure appear to be calmed for the time being. The concern now seems to be switching to coping with a spread of the economic problems seen in the US into Switzerland, which may face increasing risks as a small open economy.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.