ECB set to lay out rate hike strategy

AP News
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Posted: Apr 05, 2011 7:17 AM
ECB set to lay out rate hike strategy

The spotlight will fall on the European Central Bank on Thursday as markets look to see how aggressively the bank follows up an expected interest rate increase as it seeks to snuff out rising inflation.

Bank President Jean-Claude Trichet has made it clear that a spike in inflation is not the legacy he wants to leave when his term ends Oct. 31, and he has clearly signaled his determination to start raising rates despite the economic ripples from the disasters in Japan and turmoil in the Arab world and Europe's own debt crisis.

His stance, which has been echoed by others on the bank's rate-setting panel, has provoked concerns about the impact on stumbling economies in Portugal, Ireland, Greece and Spain.

Left to their own devices, none of those countries would be considering higher borrowing costs _ Ireland and Greece are trying to scratch out an economic future from the rubble of their bailed out economies, while Portugal is on the verge of grasping for a financial lifeline and the Spanish economy remains weighed down by an unemployment rate above 20 percent.

Because it is the monetary authority for all the euro countries, the ECB must find one rate that fits 17 countries in the context of its target of keeping inflation just below 2 percent. Trichet's repeated message in recent weeks has been that the bank must now step in to prevent a wage-price spiral in which inflation expectations become built into the economy.

"Our definition of price stability is the needle in our compass," Trichet said in a speech Monday.

Others think that stance could be too blinkered and potentially self-defeating as higher interest rates have the potential to rein in growth and accentuate the problems in the most indebted countries.

"It remains to be seen whether, in view of Portugal's imminent collapse, worrying about inflation being marginally above the 'sacred' 2 percent level is entirely appropriate at this stage," said Jeremy Batstone-Carr, director of private client research at Charles Stanley.

Away from the so-called periphery countries, such as Portugal, the economic situation is distinctly different, particularly in export powerhouse Germany, the biggest euro economy, where unemployment has fallen as low as 4.4 percent in the factory-rich southwest state of Baden-Wuerttemberg.

That partly explains why the bank is poised to raise its key refinancing rate, which determines the cost of short-term credit to banks, by a quarter of a percentage point to 1.25 percent on Thursday. It has stood at a record low of 1 percent since May, 2009.

With an increase more or less fully priced in, the bigger issue in the markets is what guidance the bank gives about future plans as inflation in March jumped to 2.6 percent, largely due to higher food and energy costs.

"In our view it is obvious that more hikes will follow," said Carsten Brzeski at ING. "With interest rates pointing north, the interesting question is whether it will hurt."

Households are not going to like higher borrowing costs in the least, especially as in many countries, such as Spain and Ireland, they are grappling with collapsing house prices as well as higher taxes.

However, Guillaume Menuet at Bank of American Merrill Lynch said the impact on Spanish mortgage payers, for instance, shouldn't be too much, given that the additional interest costs represent only a small added burden, on top of the dizzying 12 percent plunge in disposable income last year. Mortgage rates are already so low they are effectively negative when inflation is taken into account inflation.

Spanish Finance Minister Elena Salgado says Spain can absorb an interest rate increase "without any difficulty."

The ECB's stance puts the Frankfurt-based bank at odds with the U.S. Federal Reserve, which has not given any sign of raising rates from the current rock-bottom 0 to 0.25 percent range. Attention at the Fed is focusing instead on when the central bank might bring an end to its quantitative easing program, in which it in effect creates new money by buying securities from banks.

The program is regarded as carrying some inflationary risks but is intended to support growth and jobs as the economy recovers from the severe shocks of the financial and economic crisis that began in 2007.

The Bank of England also announces its monthly interest rate decision on Thursday. Even though inflation in Britain is running at 4.4 percent, the bank is expected to keep its benchmark interest rate on hold at the record low of 0.5 percent as the majority of rate-setters fret about the fragility of the economic recovery.