Slowing euro zone inflation may limit scope for ECB rate hikes

The downward trend in euro zone inflation may limit the scope for the European Central Bank to continue raising interest rates into next year, economists said.
EU statistics office Eurostat confirmed its preliminary estimate that inflation eased to 2.3 pct in August from 2.4 pct in July and 2.5 pct in June.
Core inflation also slowed, with Eurostat's preferred measure, which excludes energy, food, alcohol and tobacco, easing to 1.3 pct from 1.4 pct in July. Economists had expected this measure to remain at 1.4 pct.
The core inflation measure which excludes energy and unprocessed food slowed to 1.5 pct from 1.6 pct. This measure is closely watched by the European Central Bank.
The decline will not stop the ECB council from hiking rates again over the next three months, but it may mean that it does not need to continue tightening policy next year, economists said.
"ECB council members have a dilemma on their hands as inflation is easing, just at the point when they are looking to escalate their tightening campaign," said David Brown of Bear Stearns.
He said the downward trend in inflation will not stop the ECB from raising its main interest rate to 3.50 pct by end-year from 3.00 pct currently, as expected by markets.
"But it could definitely put a firm block on the ECB's ambition to raise rates any higher next year," he said.
Ed Teather of UBS said the ECB focuses on future inflation expectations, rather than the current headline rate, but the fact that inflation was still above 2 pct in August will support the case for further rate increases in the near term.
He said he expects the ECB to raise its main rate to 3.75 pct by the first quarter of next year.
Brown said there is a good chance that inflation could come back down to 2 pct over the next few months following the recent correction in oil prices.
Giada Giani of Lehman Brothers also expects inflation to fall to less than 2 pct over the next few months.
"The recent cooling off on energy prices is likely to display its largest impact on the September reading. The most up-to-date weekly data point to a drop in fuel prices close to 5 pct," said Giani.
"Together with the base effect as the post-Katrina surge in energy prices exits the annual comparison, this is expected to push headline inflation below the 2 pct mark for the next couple of months," Giani said.
The hike in the German VAT rate in January is likely to push inflation higher again, but the impact of this is likely to be temporary, economists said.
The ECB has previously said that it expects inflation to remain above 2 pct over the remainder of the year and on average in 2007.
In August energy prices rose 0.1 pct month-on-month but annual energy price inflation continued to slow due to favourable base effects related to last year's steep rise in oil prices.
Energy price inflation slowed to 8.1 pct year-on-year in August from 9.5 pct in July and 11.0 pct in June.
This shaved 0.1 percentage points off the headline inflation rate, said Giani.
However, food price inflation continued to edge higher, accelerating to 2.9 pct year-on-year in August from 2.7 pct in July and 2.2 pct in June.