European Central Bank signals interest rate hike over inflation fears

March 3 (Bloomberg) -- Rob Carnell, chief international economist at ING Bank NV, discusses the European Central Bank and Federal Reserve monetary policy amid rising oil prices. He talks with Maryam Nemazee on Bloomberg Television's "The Pulse."
Washington Post Staff Writer
Thursday, March 3, 2011; 10:37 PM

The European Central Bank is poised to raise interest rates next month as concerns about inflation touch off a new and potentially tricky challenge for policymakers trying to sustain the global recovery: how to temper rising prices without discouraging growth in countries with weaker economies.

The bank, which governs monetary policy for the 17 nations that use the euro, kept rates stable at its Thursday meeting. But in a news conference afterward, ECB President Jean-Claude Trichet gave what analysts called a clear sign that the bank is ready to part ways with the U.S. Federal Reserve and raise interest rates from the historic lows of the recent recession.

With inflation projected to break the ECB's 2 percent threshold this year and next, "strong vigilance is warranted" over prices, Trichet said, repeating a phrase that has been used before in signaling bank rate hikes. He also acknowledged that an increase in April is "possible," blunt language in the coded world of central bankers.

It is a stark turn after two years in which the world's major central banks have been in accord on the need to keep interest rates low to boost economic activity. Now, as world oil and food commodity prices surge, divisions among those banks are emerging.

Unrest in the Middle East has driven crude oil back above $100 a barrel, far short of its record but a rapid rise from the prices reached during the recent economic downturn. The U.N. Food and Agriculture Organization (FAO) said Thursday that its index of food prices reached a new high in February, with rising global demand and falling grain inventories expected to push costs higher over the year.

In the United States, Fed Chairman Ben S. Bernanke has argued that the Fed must remain focused on economic growth - with low interests rates and other expansive policies likely to stay in place until unemployment drops below its current 9 percent.

A boost in European interest rates would not necessarily affect U.S. monetary policy, but it could put pressure on the Fed to follow suit if prices begin rising too quickly in the United States. Unlike the ECB, the Fed has a mandate to support employment in addition to controlling inflation, and the bank could find itself caught between the two goals if the U.S. unemployment rate remains high. A wider spread between U.S. and European interest rates could also start to affect investment decisions and exchange rates; the euro rose in value Thursday even on the expectation of a European rate increase.

Bernanke said he considers the recent jump in commodity costs to be temporary, with little effect on broader measures of inflation and consumer prices.

But with the ECB's new caution, much of the rest of the world is taking a different view.

Part of the recent rise in prices has been blamed on short-term troubles - political turmoil in oil-producing Libya or bad weather for grain exporters such as Australia. But longer-run trends in demand are also at work. Asian and Latin American economies are growing fast and using more energy. The FAO's latest report based its increased estimates of world grain use on the need for corn to make ethanol or for crops such as soybeans to feed cattle to meet the higher demand for meat and dairy products in the developing world.

In the United Kingdom, inflation hit 4 percent in January - more than double the target level - and is expected to rise more this year. Some of that was triggered by a recent, broad tax increase meant to trim the country's budget deficit. But the rising inflation has put mounting pressure on the Bank of England to also boost interest rates, despite the country's weak growth forecast.

The Bank of England's interest rate committee kept rates stable at its last meeting, but the vote was divided. Analysts anticipate a rate hike later this year, and bank governor Mervyn King is having to write letters to the government explaining what the bank intends to do about inflation.

Many developing nations, including major ones such as China and Brazil, are several months into a round of interest rate increases to cool their economies. Even some developed countries, notably Australia and Canada, have begun raising rates after enjoying a strong rebound in economic growth.

In the euro zone, however, the possibility of higher interest rates complicates an already tangled situation. The ECB's priority is to restrain inflation, and major, influential economic powers such as Germany are determined to keep that focus. Germany's economy is growing strongly, and its conservative financial culture - shaped by the crippling hyperinflation the nation endured before World War II - considers rising prices a sort of primal sin that erodes the value of wages and investments.

Elsewhere in the euro zone, inflation is less of a concern - and it might even be welcome in economies that are struggling to rekindle growth. Greece, Ireland, Portugal and Spain in particular have yet to fully emerge from the recession. An increase in borrowing costs could undermine their chances of recovery.

In its statement, the ECB showed that it understood the dilemma and would continue the special bond-buying and other programs it has used to support the weaker euro-zone economies.

But the language on interest rates, analysts at London consulting firm Capital Economics wrote, was "crystal clear."

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