Bloomberg News

Trichet Signals July Rate Increase With ‘Strong Vigilance’

June 09, 2011

(Updates with economist’s comment in ninth paragraph.)

June 9 (Bloomberg) -- The European Central Bank signaled a July rate increase while damping investor expectations for further moves by reiterating a forecast that inflation will fall below its 2 percent limit next year.

The euro dropped more than a cent and German government bonds fell after ECB President Jean-Claude Trichet said the central bank hadn’t raised next year’s inflation forecast from 1.7 percent, fueling speculation it won’t increase rates as quickly as previously expected. At the same time, Trichet signaled the bank intends to lift its benchmark in July after keeping it at 1.25 percent today.

Latest data confirm “continued upward pressure on inflation” and “strong vigilance is warranted,” Trichet said. “It means that we are in a mode where there might be in the next meeting an increase of rates, but we are never pre- committed. We are not signaling any particular pace for the next decisions on our interest rates.”

While policy makers are concerned about oil-driven inflation feeding into wage demands, the danger is that higher borrowing costs may exacerbate the sovereign debt crisis that’s threatening to push Greece toward a default.

“We have little doubt that the ECB will deliver on its suggested rate hike in July,” said Howard Archer, chief European economist at IHS Global Insight in London. Still, policy makers “will be wary about raising interest rates aggressively, given the growth headwinds and euro-zone sovereign debt crisis,” he said.

Euro, Yields Drop

The euro fell to as low as $1.4478 and traded at $1.4519 at 5:37 p.m. in Frankfurt. German two-year note yields declined seven basis points to 1.61 percent and ten-year yields were down four basis points at 3.02 percent.

While the ECB today raised its growth and inflation forecasts for this year, it predicted both will slow in 2012.

The central bank increased its 2011 inflation forecast to 2.6 percent from the 2.3 percent, and left the forecast for next year at 1.7 percent. The 17-nation euro-area economy will grow 1.9 percent in 2011, up from the previous 1.7 percent projection. Growth will slow to 1.7 percent in 2012, the ECB said, reducing its forecast from 1.8 percent.

‘Further Hikes’

The 2012 inflation projection “is lower than we expected,” said Juergen Michels, chief euro-area economist at Citigroup Global Markets in London. “But that does not mean that ECB will stop hiking interest rates after the most likely move in July. We continue to expect further hikes in coming quarters unless there is a substantial economic slowdown or signs that upside inflation risks are falling sharply.”

Euro-area inflation, currently at 2.7 percent, has been above 2 percent since December. The ECB tightened borrowing costs in April for the first time in almost three years and economists surveyed before today expected it to take the benchmark rate to 1.75 percent in October.

“Risks to the medium-term outlook for price developments remain on the upside,” Trichet said. “It is of paramount importance that the rise in inflation does not translate into second-round effects in price and wage-setting behavior and lead to broad-based inflationary pressures.”

While Germany, Europe’s largest economy, is driving the region’s recovery, countries from Ireland to Portugal are struggling to grow after increasing spending cuts to rein in deficits. German Finance Minister Wolfgang Schaeuble opened a rift with the ECB this week over how to respond to Greece’s debt crisis, advocating that private investors also share the burden.

Lehman Catastrophe

The ECB has opposed anything beyond a voluntary rollover of debt to avoid what European Union Economic and Monetary Affairs Commissioner Olli Rehn has called a “Lehman Brothers catastrophe.”

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

Asked if the ECB would roll over its own holdings of Greek government bonds if private investors agree to such a move, Trichet said: “It is certainly not our intention.”

The ECB may have purchased about 40 billion euros of Greek government bonds under its Securities Market Program, while other euro-area banks may own around 10 billion euros, Barclays Capital estimates.

With banks in Greece, Ireland and Portugal reliant on central bank funding after lending dried up, Trichet said the ECB will keep its emergency liquidity measures in place for as long as necessary and at least through the third quarter. The central bank is lending banks as much money as they want at its benchmark rate for periods of up to three months.

“For the periphery, access to emergency liquidity facilities is more important than the precise level of rates,” said Holger Schmieding, chief economist at Joh. Berenberg, Gossler & Co. in London. “By prolonging its special liquidity facilities for three further months, the ECB thus continues to support the banking systems in the periphery where it matters most.”

--With assistance from Gabi Thesing and Simone Meier in Frankfurt. Editors: Matthew Brockett, John Fraher

To contact the reporters on this story: Jana Randow in Frankfurt at jrandow@bloomberg.net; Christian Vits in Frankfurt at cvits@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net


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