European Central Bank Raises Interest Rates to Fight Inflation

The Federal Reserve is unlikely to follow the European Central Bank’s (ECB) recent decision to raise interest rates and will hold off until there is looming inflation.  The ECB’s move may be the first of several this year as high oil costs drive consumer prices above its target.  That’s not to say that some members of the Fed’s policy-setting committee are not proposing an increase in the overnight lending rate by three quarters of a percentage point by the end of 2011.

Fed Chairman Ben Bernanke and New York Fed president William Dudley both believe that the economy is still to weak to remove support.  “The old analogy that the Federal Reserve removes the punch bowl just when the party gets going doesn’t apply here because, well, there is no party,” said Bernard Baumohl, chief global economist at the Economic Outlook Group in Princeton, NJ.  “There’s not even a balloon in sight.”

Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, also sees the ECB’s move as having minimal impact on the Fed. “I don’t see that a move by the ECB has any particular influence on our policy posture here in the United States,” Lockhart said.  “Obviously by increasing the differential between short-term rates in the U.S. and short-term rates in the eurozone, you can see some influence” because “exchange markets are affected by short-term rates.  I think some of the dollar selloff reflects some extent of that.”

The ECB “will hike twice in quick succession in April and June to satisfy the core economies’ demand for tighter policy,” said Stuart Thomson, a Glasgow-based money manager at Ignis Asset Management, which oversees about $120 billion.  “But the sensitivity of the peripheral economies to higher rates, both in terms of overall debt and proportion of consumer loans tied to variable interest rates, means the central bank will pause over the summer.”

The Frankfurt-based ECB raised its refinance rate to 1.25 percent from just one percent, the first increase since July 2008.  The ECB also boosted other rates by a quarter point, raising its marginal lending facility rate to two percent and its overnight deposit facility rate to 0.5 percent.  According to ECB President Jean-Claude Trichet, “We did not decide it was the first of a series of rate increases,” emphasizing that the central bank will “always do what is necessary” to assure that inflation expectations across the 17-nation eurozone are given due consideration.

The ECB has forked over billions of dollars in the last year, purchasing bonds from troubled European nations such as Greece, Ireland and Portugal – all of which have been bailed out by the European Union – to assure that they stay afloat.  The bank, whose intention is to focus on inflation is raising interest rates to combat rising prices, a major concern in Germany, which is the ECB’s most influential member.

“The ECB has decided that it will tighten policy for the core countries like Germany that are doing well and leave the non-standard measures support in place for the periphery countries,” said Silvio Peruzzo, an economist at Royal Bank of Scotland Group Plc.  “The rate increase is appropriate and there will be another one as early as June.”