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Thursday, 7 July 2011

ECB Raises Interest Rate, Brushes Off Debt Worries

By: Peter Guest

Web Producer,

The European Central Bank raised interest rates by 25 basis points to 1.50 percent on Thursday, as it continued to brush off concerns over slow growth and sovereign debt worries in the euro zone periphery. ECB President Jean-Claude Trichet hinted at his press conference that a further rise in August is unlikely.

The ECB also raised its marginal lending rate by 25 basis points to 2.25 percent and its deposit rate to 0.75 percent.

Speaking at a press conference following the decision, Trichet said that the bank will "monitor very closely" inflation in the euro zone. In the ECB's code word system, this generally indicates that the bank will not raise rates at the next meeting, analysts have said.

Trichet said that the bank was concerned about inflation, which currently stands at 2.7 percent, above the target rate of 2 percent.

Claude Trichet told a press conference following the June rate decision that the bank would be "strongly vigilant", code words for a rate hike at the next meeting, so markets had been expecting Thursday's announcement.

The ECB had been holding rates at record lows of 1 percent during the economic crisis, but with growth returning to the euro zone – led by Germany – the bank has gradually been tightening its monetary policy, raising rates by 25 basis points in April.

Saxobank group CIO Steen Jakobsen told that the rate hike was more of a political consideration than an economic one.

"I think the ECB is in a corner, and the only tool left for them to use to create some sort of noise is hiking rates," Jakobsen said.

"I think the gap between what the politicians do and the market is growing, not only in terms of defining a (Greek) default and what needs to be done in terms of the structure," Jakobsen said.

"Trichet, increasingly, at the tail end of his presidency, I think will avoid at all costs losing face, in terms of an actual default, which means that the ECB has to sit and wait, and the only thing they can signal is that they have credibility in terms of fighting inflation."

Trichet's press conference following the rate decision will give markets more indication of where rates are going. Jakobsen expected more talk of fighting inflation, but little else. Trichet has a habit of making hawkish statements one month, before stepping back the next.

"The schism is that he can only talk strong rhetoric about inflation and his credibility on inflation, but at the same time his economic fundamentals are eroding month-by-month, even in Germany," he said. "The spread between his rhetoric and his practical ability to manoeuvre is limited."

"Hiking (rates) now, and indicating another one right away would be giving away his cards. From a game theory point of view, if nothing else, playing into an October hike would be too early," Jakobsen said.

He added that the markets may not be convinced by today's decision.

"If the market calls (Trichet's) bluff, saying, well, you're hiking rates for political reasons only, then the reaction should be that people will start buying bunds and spreads in the periphery will go up," he said.

Jakobsen also noted that the ECB has been "backed into a corner" by its balance sheet, which has seen the bank take a large exposure to peripheral countries' debt.

Research from HSBC showed that the euro system – the ECB and euro zone central banks – could stand to lose 23 billion euros on their bond holdings in peripheral countries, in the event of a 50 percent haircut on Greek, Portuguese and Irish debt.

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