Oil the key driver of rate outlook according to Bank of Ireland

Higher energy and food prices have boosted headline inflation
...and ECB ready to hike rates despite economic slowdown

"Last September inflation in the euro area was 2.1%, having climbed above the ECBs target for the first time in a year. Energy, which accounts for some 10% of the total price index, had risen by 3% over the previous twelve months, but since then the annual inflation rate in energy has surged to 13.7%. Food prices (accounting for some 16% of the index) have also risen sharply, from an annual rate of 2.4% to 6.4%, and these two categories have been the key drivers in pulling the euro zone annual inflation rate up to the current 3.7%", according to Bank of Irelands June Bulletin which was published today, 27 June 2008.

Commenting, Dr Dan McLaughlin, Group Chief Economist, Bank of Ireland and author of the Bulletin said: "This acceleration has proved a move too far for some members of the ECB Governing Council, and it seems that the Bank is set to raise rates by a quarter of a percent in July, contrary to our and most of the markets expectation that the next move would be down. Indeed, the market has now switched to fully pricing in a half point rise in rates by year-end. Higher rates will not affect inflation in the short-term, but the rationale is that it will help to anchor inflation expectations and convince firms and households that the ECB will do all it can to bring inflation back to the target. The proposed rate-rise occurs against a backdrop of slowing economic activity, (the latest PMI index implies that the euro zone had negative growth in June), which should eventually lead to a fall in inflation, but the ECB Governing Council appears unwilling to wait for this to happen".

Concluding Dr. Dan McLaughlin said: "In truth, consumers expectations of inflation probably owe more to their recent experience of inflation, particularly high frequency purchases such as food and energy, than to Central Bank monetary policy. In that sense the near-term path of oil prices will prove decisive in determining headline inflation, expectations and hence ECB policy. Crude oil has risen by over 35% in the past few months, having doubled in 2007 in dollar terms, and if it stabilises at current levels inflation in the euro area is likely to fall steadily from September, helped by positive base effects from food, albeit with a strong risk that it creeps higher near-term. Should this scenario unfold, or if oil prices fall, the ECB may limit its tightening to a quarter point. A further acceleration in oil prices and further spike in headline inflation may mean even tighter policy, however, even though the resultant slowdown would be such that the ECB would probably end up cutting rates aggressively in 2009. The short term outlook is therefore unclear, but with rates now unlikely to fall this year as we expected the euro may end the year around $1.50 instead of the $1.40 we had forecast".

Ends

27th June 2008

For reference:

Dr. Dan McLaughlin
Group Chief Economist
Bank of Ireland Global Markets
Tel: 01 609 3221

Anne Mathews
Media Relations Manager
Group Corporate Communications
Bank of Ireland
Tel: (01) 604 3836 / 087 246 0358