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ECB raises interest rates to fight stiff inflation

Latest update : 2008-07-03

The European Central Bank has pushed its benchmark rate to 4.25 percent. The ECB hopes to ease inflation despite risks of slowing the euro zone's growth. (Analysis: D. Herbert, Business Editor)

The European Central Bank (ECB) raised its main interest rate by a quarter of a point to a seven-year high point of 4.25 percent on Thursday to choke record inflation.

Financial markets focused however on what might lie ahead amid rapidly growing evidence of a sharp slowdown in the 15-nation economy.

The Swedish central bank also raised its benchmark rate by a quarter of a point to 4.50 percent, ahead of the ECB decision, to curb price increases felt by consumers around the world, and signalled further rises later this year.

In Frankfurt, attention turned to a press conference scheduled by ECB president Jean-Claude Trichet and a statement explaining the bank's decision, which came after eurozone inflation hit a record 4.0 percent in June.

While most analysts believed the bank would now keep its main refinancing rate stable for the rest of 2008, financial markets saw it heading higher, with the three-month Euribor contract implying a policy rate of around 5.0 percent.

The central bank directly affects short-term market rates by the level at which it sets its own benchmark, but longer-term rates are set by market forces based on several factors, notably prospects for long-term inflation.

An economic slowdown normally eases pressure on inflation.

But investors' response to the rate increase "will depend more on the accompanying statement and press conference" by Trichet after the decision is announced, Capital Economics said.

Bank of America economist Holger Schmieding added: "What matters is the precise wording of the forward-looking sentences at the end of the top paragragh."

They could "leave the rate outlook wide open," or signal the bank was now leaning towards maintaining a stable rate in the coming months or raising it again before the year was out, he noted.

"Our best guess is that the ECB will not be able to reach a near-consensus on the way forward today and will thus not send a clear message on the future rate outlook," Schmieding said.

With economic indicators showing the 15-nation economy slowing down quickly, dogged inflation -- some see it reaching 4.2-4.3 percent in August or September -- has put the ECB in a bind.

A purchasing manager's index indicated Thursday that business activity contracted slightly faster in June than first estimated, pointing to a contraction for the first time in three years.

"Available data confirm the sharp slowdown of the eurozone economy," said Natixis economist Cedric Thellier, as companies face cloudy consumer sentiment, tighter credit conditions, weaker foreign demand, and a stronger euro that makes exports less competitive.

The single European currency has risen above 1.58 dollars owing in part to a widening difference between the ECB's main rate and the US Federal Reserve's Fed funds rate of 2.0 percent that helps underpin the US economy but also fuels oil price rises.

Not only is oil priced in dollars, so prices rise as the dollar falls, but also investors have ploughed into the commodity as a hedge against the US currency's decreasing value, pushing prices up further.

On Thursday, oil prices hit a new record above 146 dollars a barrel.

Eurozone political leaders worry however that raising the zone's main lending rate will put the screws to economies that are either weakening, like in powerhouse Germany, or flirting with recession, like in Ireland and Portugal.

But Trichet said on Thursday in the German daily Die Welt that the ECB must counter risks "that inflation could explode."

Eurozone producer prices leapt by 7.1 percent in May on a 12-month basis, the biggest increase since the European Union's Eurostat office began gathering data in 1990.

Producer prices also rose by 1.2 percent from April, indicating higher retail inflation in the coming months as companies passed on increases to the public.

The ECB also increased on Thursday its other two key rates -- the deposit rate and the marginal lending rate -- by 0.25 percentage points to 3.25 percent and 5.25 percent respectively.

Date created : 2008-07-03