Markets braced for ECB rate hike

FRANKFURT: Financial markets were braced for a European Central Bank interest rate hike Thursday, the first since July 2008, but wonder how it could effect struggling peripheral eurozone economies. Analysts are also speculating on how big an increase the ECB might unveil, and whether it would be the first of a series that could extend into 2012. ECB president Jean-Claude Trichet said last month that the bank's record low rate of 1.0 percent might be raised amid concern that inflation now at 2.6 percent could spiral out of control. Subsequent comments by Trichet and other bank officials along with economic data have made a rate hike almost certain despite the Japanese crisis and unrest in the Middle East.

Inflation exceeds the ECB's target of just below 2.0 percent, and a eurozone producer price index posted its biggest jump in almost two-and-a-half years in February, underscoring concern about inflation expectations. But countries like Greece, Ireland and Portugal that are struggling with public deficit and debt crises will not welcome higher rates appropriate for stronger economies such as those in France and Germany. Market anticipation of rate hikes has pushed the euro above 1.41 dollars, putting an added burden on weaker countries, and "fears of future eurozone government debt restructurings look set to continue to grow," Capital Economics economist Jonathan Loynes said. The ECB has taken care however to maintain generous cash loans to commercial banks across the 17-nation region so money markets function smoothly. It also said last week that all bonds issued or guaranteed by the Irish government would be accepted as collateral for central bank loans, easing specific pressure on Irish banks.

The move came after Dublin revealed its banking sector needs a complete overhaul, with the cost of bailing out commercial lenders set to top 70 billion euros ($99 billion). Elsewhere, the ECB is encouraged to see that credit conditions on which modern economies depend have improved, with loans to the private sector growing by 2.6 percent in February. The eurozone economy is sending mixed signals in fact, with an index for manufacturing and services output edging lower in February and showing wider disparities between core countries and others. A monthly fall of 0.1 percent in February retail sales will also foster concern that inflation and austerity measures could undermine consumption. Economists nonetheless expect the ECB to raise its benchmark interest rate to at least 1.25 percent, and have not ruled out a jump to 1.50 percent as a signal to markets that it is serious about fighting inflation. And though Trichet has said it would not be the first of a series of rate hikes, many observers anticipate at least one and possibly two more this year.

"We expect this to be the start of a series of ECB rate hikes, probably one 25bp (basis points) move per quarter," Berenberg Bank chief economist Holger Schmieding said. The ECB is keen to move monetary policy back towards normal, and is pressing governments to resolve solvency problems and bolster fragile banking sectors. But Greece, Portugal and Spain look set to run higher-than-forecast public deficits and Ireland will struggle to restructure its shattered banks. With higher interest rates, "budget consolidation in the EU peripherals will not be a piece of cake in 2011," Commerzbank analyst Christophe Weil concluded.