ECB raises rates as expected, seen firm on Greece

Friday, 8 July 2011 04:16 - - {{hitsCtrl.values.hits}}

(Reuters) - The European Central Bank raised interest rates for the second time this year on Thursday, tightening policy to address above-target inflation in the euro zone despite the intensifying debt crisis in Greece.

The rise in the ECB’s benchmark interest rate to 1.5 percent was widely expected after the bank’s recent reiterations that it is in a mode of “strong vigilance” -- code traditionally used to signal a hike.

“No surprise at all,” Berenberg economist Holger Schmieding said of Thursday’s 25 basis point rise in the ECB’s main refinancing rate to 1.5 percent.

“It is appropriate given that the euro zone economy has apparently expanded at a pace slightly above trend in the first half of the year, and given that inflation is above target.”

The ECB raised its subsidiary overnight deposit and borrowing rates in unison, opting not to re-widen its so-called rate ‘corridor’ this time around.

Euro zone inflation held at 2.7 percent in June, softer than expected but well above the ECB’s target of just under 2 percent. A surprise decision to hold rates because of Greece’s troubles would have alarmed financial markets primed for a hike.

In contrast, the Bank of England kept rates on hold on Thursday.

Attention will now turn to ECB President Jean-Claude Trichet’s 1230 GMT news conference for any indications he gives on the bank’s policy intentions for the remainder of this year.

Markets are eager to hear the ECB’s view on whether signs of a slowdown in the euro zone economy represent a ‘soft patch’ or a more marked deterioration.

Recent euro zone data has generally disappointed. The latest industrial orders rose less than expected, while growth in the bloc’s dominant service sector has also slowed sharply.

A Reuters poll found economists have softened their rate hike view as the euro zone debt crisis has escalated over the last month.

Rates are expected to rise just once more this year, to 1.75 percent, with only two quarter point increases forecast to follow for all of next year.

If Trichet says policy remains “accommodative” and the bank will monitor inflationary pressures “closely” or “very closely”, expectations will be cemented for another hike this year -- likely to be between October and December.

PERIPHERY PROBLEM

Beyond monetary policy, much of the ECB’s news conference will focus on its stance on Greece and the euro zone periphery.

The downgrading of recently bailed-out Portugal’s credit rating to junk rattled financial markets on Wednesday and cast new doubt on European efforts to rescue distressed euro zone states without debt restructuring.

The ECB is proving a major stumbling block in agreeing a second rescue plan for Greece as it has threatened to refuse to accept restructured Greek bonds as collateral in its lending operations in the event of a default or a “restricted default”, which ratings agencies are threatening to impose.

Refusing to accept Greek bonds as collateral would deprive Greek banks of the funds on which they rely, crippling the Greek economy and risking contagion to other euro zone economies.

By threatening to use this ‘nuclear option’, the ECB hopes to press the governments into avoiding a downgrade to default status, and the contagion it fears would follow.

“(Trichet) may marginally soften his line on Greek debt rollover without backtracking significantly,” Schmieding said.