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Eurozone interest rates set to rise as inflation erupts

Latest update : 2008-06-29

Eurozone borrowing costs are set to rise when the European Central Bank convenes Thursday, seeking to tame a fledgling inflation monster before turning its attention to slumping growth.

Interest rate cuts "will not be on the agenda until the all-clear is given on the inflation front," Commerzbank economist Ralph Solveen said.

"Only by the turn of the year will the economy be weak enough to curb wage growth and reduce inflation risks," he added.

With record 3.7 percent eurozone inflation shredding consumer confidence and expected to rise higher, the ECB is determined to clamp down as oil prices set new records of their own over 140 dollars a barrel.

"Price pressures are showing no signs of letting up," noted Jennifer McKeown at Capital Economics, even as business activity begins to stagnate, signalling the start of a phenomenon known as stagflation.

Central banks normally cut interest rates to boost a slowing economy but if inflation rises, they must hike borrowing rates to keep living costs in check.

Last month, ECB president Jean-Claude Trichet said the bank could raise its main lending rate "by a small amount" in July, probably from 4.0 percent to 4.25 percent, to dampen expectations that inflation will spiral out of control.

That ECB rate compares with the US Federal Reserve's level of 2.0 percent, and the Bank of England's 5.0 percent, which was expected to remain unchanged Thursday following a meeting of BoE policymakers in London.

Meanwhile however, a relentless climb by oil, commodity and food prices has combined with other factors to weaken global economies, including that of the 15-nation eurozone.

The other causes include the euro's strength against foreign currencies, tighter monetary conditions in countries like Brazil, Russia, India and China, more restrictive credit conditions in general and weak US consumer demand.

As a result, eurozone economic confidence has fallen to a three-year low, the European Commission (EC) said Friday, with manufacturing affected in particular.

The survey also revealed an increase in inflation expectations that was sure to worry ECB policymakers, who stress they will act to keep inflation fueled by energy and food costs from becoming reinforced by higher wages and other price hikes.

"We think this is the early stage of a prolonged cyclical downturn," said Marco Valli, vice president at UniCredit Markets & Investment Banking.

The EC survey "echoes other recent survey evidence in warning of a sharp slowdown in activity over the coming quarters," added Jonathan Loynes, chief European economist at Capital Economics.

But according to Solveen at Commerzbank: "The ECB has not been impressed by this, at least so far, and continues to point to substantial inflation risks."

In Germany, the biggest European economy, consumer prices increased by 3.3 percent in June, ensuring the eurozone rate would rise as well.

Solveen noted that the bank "has already effectively announced a rate hike," while estimating inflation could hit 4.0 percent by August.

Most analysts would point again in that case to the effect of high oil prices, but the president of OPEC sought last week to lay blame at the feet of the ECB itself.

Algerian Energy Minister Chakib Khelil said that in the short term, "everything depends on the European Central Bank and a decision it could take to raise eurozone interest rates."

A rise would push the euro higher against the dollar since euro-denominated investments would provide greater yields.

"At that time, I think the price of oil will increase" too, Khelil said.

Many analysts say oil prices have risen because investors have bought "black gold" as a hedge against a falling dollar.

Date created : 2008-06-29