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The problem for the euro zone and the ECB in particular is quantum

The pound remains in touching distance of its highest level against the euro since August 2010 after ‘sticky’ UK inflation data gave the pound support.

Data out yesterday from the Office for National Statistics (ONS) showed that in March, UK inflation rose slightly on the month before. The Consumer Prices Index (CPI) measure of annual inflation stood at 3.5% in March 2012, up 0.1% from February’s figure. The rise was driven by food, clothing, recreation and culture price increases according to the ONS data.

Meanwhile, the Retail Prices Index measure now stands at an annual inflation rate of 3.6% in March 2012, down 0.1% from February’s figure of 3.7%.

The rise in the CPI rate of inflation will cause some concern to the Bank of England which has staked its reputation on inflation slowing across 2012 and returning to its 2% target.

Vicky Redwood, Chief UK Economist at Capital Economics, said the rise should only be temporary, particularly as last year’s rises in energy prices continued to fall out of the annual comparison.

Dr Howard Archer, Chief UK Economist at IHS warned that while inflation still seemed likely to eventually trend down appreciably further, there was “a very real danger that it will prove sticky over the next few months as high oil prices impact”.

The pound was also helped by the continuing pressure on the euro after Spanish bond yields exceeded 6% at Monday’s auction for the first time since November 2011. It is worth bearing in mind that when the bond yields of Greece, Ireland and Portugal exceeded 7% over the last few years triggered the multiple bail-outs from the European Union (EU), International Monetary Fund (IMF) and European Central Bank (ECB).

Yesterday Spanish bond auction went slightly better than Monday’s as stronger than expected demand for Spanish debt was shown with the Spanish Treasury managing to sell more than €3 billion in short term bills. However they were only sold with higher yields amid concern about Spain’s economic outlook. Even upbeat German business sentiment data failed to lift the pressure on the euro.

The IMF reported yesterday that it has raised its global growth forecast for 2012 and 2013 due to improved financing conditions and the easing of the financial crisis. However, it warned that the economic recovery will remain fragile. In its report, the IMF raised its 2012 global growth forecast from 3.3% to 3.5% and the 2013 estimate from 3.9% to 4.1%. It however remains seriously concerned about the euro zone suggesting in its report that the euro zone is expected to close 2012 in a recession. The IMF sees a 0.3% contraction in 2012 before the euro zone returns to 0.9% growth in 2013.

The IMF also singled out Spain by lowered its growth forecast and now expects a contraction of 1.8% for this year compared to its previous estimate of 1.6%. Spain is the only country that has been singled out in this way.

The IMF stated that the European Central Bank (ECB) still has manoeuvring room to lower rates further and that the China may see a smooth landing.

In an article in the FT, Portuguese Prime Minister Pedro Passos Coelho restates his confidence that Portugal will be able to return to the financial markets in 2013 but does admit that there can be no guarantees in times of such uncertainty. “Portugal will prove the doubters wrong in 2013” is the title of Passos Coelho’s opinion piece published in this morning’s edition of the FT.

In a clear response to those who believe his country will be unable to return to capital markets before September 2013, need a second bailout or have to restructure debt, the Portuguese leader is unwavering: “I believe they are wrong.” Even so, he admits that despite Portugal’s commitment to fulfilling its obligations and being “optimistic” on the outcome it is important to recognise possible risks.

Italy meanwhile seems to also be feeling the difficulties affecting Spain after Italian Premier Monti suggested that it may also be pushing back the date by which it will be able to achieve a balanced budget.

According to a budget draft seen yesterday, due to weaker expectations for growth this year (the country now estimates a 1.2% contraction compared to the prior 0.4% slump), Italy will raise its 2012 deficit target to 1.7% of GDP from the prior 1.6%, and the number will rise to 0.5% for next year from the earlier 0.1% estimate. In these circumstances, the country now expects the budget to be balanced by 2014. While Italy has one of the smallest deficits in the euro zone, its overall debt to GDP ratio is second only to Greece.

The problem for the euro zone and the ECB in particular is quantum. Greece, Ireland and Portugal are the three smallest economies in the euro zone. Italy is the third largest and Spain the fourth.