Mooted ECB rate hike highlights eurozone plight

6th March 2011, Comments 0 comments

A huge European Central Bank hint at a rate hike next month jolted markets and highlighted the ECB's predicament faced with rising inflation and a three-speed eurozone recovery.

"The contrast between financial crises at the periphery and a strong Germany could really make things extremely difficult for the ECB," Berenberg Bank's senior economist Holger Schmieding told AFP last week.

He referred to struggling economies such as Greece, Ireland and Portugal.

Schmieding spoke after ECB president Jean-Claude Trichet suggested the central bank would raise lending rates in April to combat inflation which hit 2.4 percent in February.

An interest rate increase "is possible," but "not certain," Trichet said, which markets interpreted as a sign it would probably happen.

The rate has been at a record low of 1.0 percent since May 2009 but is no longer appropriate for Germany where the economy has bounced back from recession and might be starting to overheat.

The 17-nation eurozone also includes Greece however, which is still in recession, along with others where timid signs of growth have appeared and stronger states like Austria, Finland and France.

The ECB has also oriented exceptional cash supply measures towards banks in weaker countries and Trichet said it would keep providing unlimited liquidity through June at least.

The bank's apparent decision to raise the benchmark interest rate for 330 million people before a recovery was ensured for all was disputed by many economists, but Schmieding said the ECB was "doing it exactly the right way."

A higher rate should dampen inflation expectations, while fragile banks would not suffer unduly since ample cash would still be available.

The situation nonetheless underscores a core issue for the 17 nations and a single central bank, the trouble in finding one monetary policy for all, what Thorsten Polleit at Barclays Capital called "the curse of the compromise."

Eurozone founders assumed member's economies would gradually converge, but 12 years on some have not and "a lot is really in the hands of the individual governments," ING senior economist Carsten Brzeski said.

Eurozone and European Union leaders are to meet this month to discuss a permanent rescue mechanism for heavily-indebted countries and possible economic reforms, but expectations for a broad and deep agreement have dwindled.

Some analysts think the mooted ECB rate hike was also aimed at focusing political leader's minds on the problems at hand, like how to compete with emerging economies.

For that, "there is nothing the central bank can do," Brzeski said, while Schmieding added: "The heavy fiscal lifting and the institutional reform has to come from governments and finance ministers."

Capital Economics economist Jonathan Loynes said: "Crunch time for eurozone policymakers could be approaching and the stakes are higher than ever" because dithering by EU leaders could provoke a sharp reaction from markets and see the debt crisis take a turn for the worse.

Germany and France have come up with ways for partners to become more competitive but many of the ideas have been rejected by governments or watered down and Berlin criticised for seeking to impose its model on others.

Brzeski underscored differences between the eurozone's industrial- and agricultural- or service-based economies and concluded: "We don't need a monetary union with 17 Germanies."

As far as narrowing the gap between the rich and the poor, he and Schmieding see only longer-term solutions.

Once housing and labour markets rebound in Ireland and Spain for example, structural reforms will help close the gap with Germany, which will cool down at some point as well.

Meanwhile, "the debt problem is unlikely to be solved with monetary policy without causing other problems, most notably inflation problems," Barclay's Polleit said.

And even with help from the ECB and EU funds, indebted states will probably suffer for a few more years, as Germany did until painful reforms finally bore fruit, Brzeski forecast.

"It's simply something that takes awhile," he said.

© 2011 AFP

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