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The illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in Frankfurt April 5, 2011. (KAI PFAFFENBACH/REUTERS)
The illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in Frankfurt April 5, 2011. (KAI PFAFFENBACH/REUTERS)

ECB vows to fight inflation Add to ...

Even as the gulf widens between the stronger euro-zone core countries and the shrinking economies on the troubled periphery, the European Central Bank has signalled it fully intends to ratchet up interest rates to check inflation.

The ECB left its benchmark interest rate unchanged at 1.25 per cent at its policy-setting meeting Thursday, but left little doubt that another rate hike is coming as early as next month, despite the further damage it could inflict on such hard-hit member states as Greece, Portugal, Ireland and Spain. The bank did extend its emergency liquidity operations for at least another three months, to ensure that banks operating in these countries retain access to sufficient operating capital.

But ECB president Jean-Claude Trichet underscored the bank's adamant opposition to any sort of debt restructuring by Greece or other euro-zone members, partly because of the potential repercussions not only for the single-currency region but the global financial system. "It would be an enormous mistake to trigger a credit event," Mr. Trichet said at a news conference explaining the reasoning behind the bank's moves.

Analysts say some form of default is inevitable. They believe the ECB is opposed because the value of the billions of euros in sovereign bonds it holds - both directly and as collateral for loans to the troubled financial systems in Greece and elsewhere - would plummet. Mr. Trichet denied the bank is acting out of self-interest.

"We are not in favour of restructuring, haircuts and so forth," Mr. Trichet said. "We call for avoiding all credit events and selective defaults. We exclude all elements which are not voluntary."

The central bank last raised its key rate in April, by a quarter of a percentage point, and is expected to stick to similarly modest increases in the months ahead because of the economic risks, the continuing debt crisis and its own forecast that inflation will moderate next year.

"On balance, risks to the outlook for price stability are on the upside," the ECB said. "Accordingly, strong vigilance is warranted. On the basis of our assessment, we will act in a firm and timely manner. We will do all that is needed to prevent recent price developments giving rise to broad-based inflationary pressures."

In the past, the "strong vigilance" comment has typically been followed by tighter monetary conditions.

The central bank "obviously believes that the best way to contain inflation and pricing expectations is by raising interest rates again sooner rather than later, thereby sending out the message that it is not willing to take risks on the inflation front despite significant euro-zone growth uncertainties," said Howard Archer, chief European economist with IHS Global Insight in London. "Further out, we see one more increase this year, to 1.75 per cent in the fourth quarter."

Rates could hit 2.5 per cent by the end of 2012, Mr. Archer forecast.

Separately, the Bank of England kept its benchmark rate at a record low 0.5 per cent Thursday, as a stagnant economy trumped rising inflation concerns in Britain. The rate was last changed in March 2009. This leaves the Bank of England and the U.S. Federal Reserve as the only major central banks that have not shifted, at least modestly, into a policy-tightening mode.

Unlike the Federal Reserve, the ECB has no mandate to deal with unemployment or other economic ills. Its role as a lender of last resort to insolvent governments and banks was foisted on it by European leaders.

The ECB "allowed itself to be used by governments that should have provided the bailout money directly," said Raghuram Rajan, a finance professor at the University of Chicago. "It was politically expedient but destructive of institutions."

Mr. Trichet told reporters inflation will remain well above the bank's target of close to 2 per cent in coming months, mainly because of higher energy and other commodity prices. The bank forecasts consumer inflation will average 2.6 per cent this year, easing to 1.7 per cent in 2012.

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