'Risk repricing in euro area permanent'

ANALYSTS' VIEW

Whether the ECB hikes rates on September 6 probably depends on market developments. We now see dented confidence, tighter credit and a slower world economy crimping growth. Phase I of the current crisis seems to have passed, with financial markets having settled a little.

Although dislocations remain in credit markets, elsewhere stability has started to return. Of course, financial markets remain vulnerable but continued volatility in short-term interest rates and disclosure of sub-prime losses now seems to be in the price of other financial assets.

The reality is that the governing council is far from decided on whether to raise rates, as it had originally planned. In principle, postponing the planned rate hike is an attractive option. The ECB governing council also needs to consider that the Federal Reserve still looks likely to cut rates on September 18.

As for postponing the rate hike by more than a month, in addition to possible Fed rate cuts and all the communication difficulties, the likely hit to confidence data globally over coming months could well make the planned rate hike hard to reinstate "� even if the dip in confidence is viewed in Frankfurt as likely to be only transitory.

More substantively, there is a clear desire among central banks, particularly in Frankfurt, to orient monetary policy towards price stability and to use it for financial stability only if absolutely necessary.

That said the prospect of a knock-on effect from this re-pricing of risk to growth and inflation means that a decision to abandon the planned hike on price stability grounds is possible.

Consequently, much now depends on how financial markets evolve and whether they continue to thaw.

In our view, the primary intent of restating the August 2 monetary policy stance was simply to ensure that the ECB retains its options. Prior to the publication of its statement, the governing council was in danger of being cornered by market expectations that it would abandon its plan to hike rates.

When it is deliberating its decision for the September governing council meeting, an important issue for the ECB will be the possible ramifications of recent developments.

We also think there will be hits to the domestic euro area economy. To the extent that the repricing of risk is permanent, recent developments suggest two things. First is that the activity of the financial sector is likely to slow.

Fortunately, for the euro area, this constitutes a relatively small part of the economy and has contributed in only a small way to the recovery.

Second is that bank lending standards are likely to tighten. Using data from the ECB's bank lending survey it seems that changing risk perceptions have been the most important driver of easier lending standards in recent years.