Earlier in the year I suggested the ECB would be in a position to cut rates by May (for example here). While the economy has slowed as expected, the forecast has been undermined by a further rise in headline inflation, mainly due to soaring food and energy prices.

My ECB-ometer forecasts an “average interest rate recommendation” of the 21 Governing Council members of -0.01% at this week’s meeting. This is well above the -0.125% threshold for a cut and up from -0.05% in April. The increase over the last month reflects a fall in the euro and improved credit market conditions, which have offset further weakness in business surveys and a slowdown in money supply growth.

The chart presents the ECB-ometer’s output in terms of the probability of a rate change. (Previous posts have shown the average interest rate recommendation.) The chances of a rate cut are estimated to have fallen from 40% in March to below 10% this month.

While the model has become less dovish, it continues to suggest a slight easing bias is warranted by incoming data. This is at odds with the policy statement issued after last month’s meeting and raises the possibility that ECB President Trichet will be less hawkish in his remarks tomorrow.

Activity data should deteriorate further over coming months but recent energy price strength will delay a retreat in headline inflation. I am pencilling in a rate cut in the third quarter but it currently looks far from certain.