ECB to tread softly with historic rate rise

ECB to tread softly with historic rate rise

Frankfurt: The European Central Bank is poised to raise interest rates from a record low 1.0% on Thursday and more is likely to follow but, fearful of heaping more pain on the euro zone’s stragglers, it will give few clues about when the next move will come.

ECB policymakers have been out in force in recent weeks flagging a rise that will be their first since July 2008. All but four of 80 economists polled by Reuters last week expected it to raise rates by 25 basis points.

The policy making governing council started its meeting at 12.30 pm. Its rate decision - due at 5 .30 pm - will come less than 24 hours after Portugal announced it was seeking European Union support, a decision long expected by financial markets.

Lisbon’s announcement has not changed market expectations for a rise in rates but ECB President Jean-Claude Trichet’s news conference at 6 pm will be eyed for signs markets are still justified in expecting more than one further move this year.

The lights on 36th floor of the ECB’s building, where the council’s meetings take place, were still burning brightly at midnight Frankfurt time following Portugal’s call for aid.

For months the central bank has been privately pushing Lisbon to accept assistance and the fact it has finally happened may free the ECB to take a firmer line on the budding inflationary risk.

The ECB is concerned that firm oil prices - near 2-1/2 year highs - could boost inflation expectations and financial markets are pricing in two further quarter-point rises in interest rates this year to follow a move on Thursday.

But the Frankfurt-based bank must be careful not to hurt the euro zone’s struggling economies by jacking up rates fast and Trichet, who shocked markets last month by signalling an April hike, may not want to heighten expectations for further rises.

“I think it is the start of a series but I think Trichet ... will try to temper any market expectations, which are already priced in, of further hikes to come," said Lloyds interest rate strategist Eric Wand.

Bank-to-bank lending rates have already risen on rate hike expectations. The three-month Euribor rate has risen 25 basis points since the start of the year and hit its highest level since June 2009 on Wednesday.

With Greece, Ireland and Portugal all being forced to rely on international bailouts and struggling to generate growth, the rate hike will carry risks. But the central bank believes it can tighten policy slowly enough to avoid doing serious damage.

It feels re-establishing its inflation-fighting credibility is more important to avert an upward spiral of prices and wages. Euro zone inflation rose to 2.6% last month, above the ECB’s medium-term target of just below 2.0%.

“Typically, rate expectations move very quickly once the hiking cycle starts and I think Trichet knows the recovery is still quite fragile on the euro area aggregate - the periphery is still struggling," said Nomura economist Jens Sondergaard.

“It’s a tricky act for them. They don’t want to signal that this is the start of a hiking cycle. On the other hand, I don’t think they can be too complacent on inflation at the moment."

The euro slipped from recent peaks ahead of the meeting.

“The euro has rallied considerably on the ECB rate hike view but it may be the case of buy the rumour sell on the fact," said Koji Fukaya, chief FX strategist at Credit Suisse.

“The euro zone debt crisis has not stopped the ECB from making hawkish comments. That means Portugal’s story is not going to stop a rate hike. The market is pricing in 100 bps of rate hikes, but it may be difficult for us to really see that."

Tempering expectations

Last month, Trichet dusted off the phrase “strong vigilance", which in the past signalled a rate rise was only a month away.

If, at Thursday’s news conference, he omits a reference to rates being “appropriate" and says the ECB is monitoring inflation “very closely", markets will expect another rise in the coming months. But economists expect him to be coy.

The ECB may soften the impact of its key refi rate hike by leaving a subsidiary rate unchanged - a move that will be closely watched to gauge just how nervous the bank is about inflation and how much pain it thinks the periphery can bear.

The ECB’s overnight deposit rate, which acts as a floor for short-term market rates, could be exempted from the hike and left at 0.25%. This would make the refi rate rise largely symbolic; actual money market rates which guide the cost of bank borrowing might barely move.

An important issue that Trichet may have to dodge is when the ECB will phase out its offers of unlimited loans. These were introduced as an emergency step but have now become a liability, injecting so much money into banks that the ECB cannot effectively control market rates.

Last month, euro zone official sources told Reuters the ECB was close to creating a new liquidity facility that would support weak banks in Ireland and elsewhere, helping it eventually to phase out unlimited loans.

However, disagreements within the governing council over how much aid the central bank should provide to countries have caused that plan to be suspended. In the absence of an alternative to unlimited loans, Trichet will probably be unable to say anything explicit about ending them.