Doubts rise over ECB rate hike after Japan quake

By David Mchugh

Associated Press

Published: Thursday, March 17 2011 11:40 a.m. MDT

The President of the European Central Bank, Jean Claude Trichet, left, talks with Spain's Finance Minister Elena Salgado at the start of an Eurogroup meeting at the EU Council in Brussels, Monday March 14, 2011.

Geert Vanden Wijngaert, Associated Press

FRANKFURT, Germany — Market certainty is eroding that the European Central Bank will follow through with an interest rate hike it has all but promised, due to the financial turmoil unleashed by Japan's natural disasters and unresolved nuclear crisis.

While many economists have said the ultimate impact on the global economy is still difficult to assess — and might be modest — the market jitters could cause the bank to pull back from its March 3 statements that many took as a near-guarantee it would raise its key rate.

Bank President Jean-Claude Trichet said then that the bank would exercise "strong vigilance" on inflation — taken as a code word that an inflation-fighting increase was imminent to prevent inflationary expectations from becoming built into the economy. Consumer prices increased 2.4 percent in April in the countries that use the euro — above the bank's goal of just under 2 percent.

Since then, violent uprisings in the Middle East have pushed oil prices to two-year highs — and continue to threaten instability across the region — and Japan's disasters triggered days of panic on financial markets.

"If in the run-up to the April ECB meeting stock prices were to remain under severe pressure and volatility stayed elevated, the central bank would have to reconsider its position on rates," Marco Valli, chief eurozone economist at Unicredit Research, said Thursday.

If the ECB holds off, it would be a rare about-face for Trichet and the bank's governing council but not unprecedented — the bank reversed the course of its monetary policy at the start of the financial crisis in 2007.

Financial markets suggest investors are prepared for such a scenario. Expectations for overnight interest rates in the eurozone a year from now have slipped to 1.65 percent from 1.9 percent immediately after Trichet's statement. The drop would amount to removing one quarter-point increase from the bank's actions over the next months.

But not everyone agrees. "At this stage, we doubt that the horrific and tragic events in Japan will deter the ECB from acting, as the economic effects on the eurozone currently look unlikely to be appreciable," said Howard Archer at IHS Global Insight.

He expects a rate increase of a quarter percentage point at the April meeting.

There is only one precedent for the bank announcing "strong vigilance" and then not following through. That was in August, 2007, when the bank reacted to the sudden worsening of the sub-prime mortgage crisis in the United States by reversing course and pouring credit into the banking system instead of tightening down, according to analyst Nick Mathews at RBS.

The ECB's move will in part depend on whether the economic uncertainty over Japan eases some of the recent upward pressure on oil prices, said Mathews. If other stock markets sag like Japan's Nikkei, "that would argue in favour of the ECB delaying rate hikes."

So far, stock markets have taken a sharp hit, though they steadied on Thursday, with European and U.S. indexes up 1 to 2 percent.

The ECB's key rate is at a record low of 1 percent, where it has been since May 2009 to support growth through the financial and debt crises. But now that Europe's economy is recovering, the bank has said it is wary of workers and businesses building higher costs — largely from rising food and energy prices — into their wage and price agreements.

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