Trichet May Signal July Increase as ECB Holds

European Central Bank President Jean- Claude Trichet may signal the bank intends to raise interest rates in July after leaving the benchmark unchanged today.

ECB officials kept the key interest rate at 1.25 percent, as predicted by all 52 economists in a Bloomberg News survey. Trichet is likely to call for “strong vigilance” on inflation, indicating a rate increase next month, a separate survey shows. He holds a press conference at 2:30 p.m. in Frankfurt, during which the central bank will also publish its latest economic forecasts for this year and next.

ECB policy makers are concerned about oil-driven inflation feeding into wage demands. Their task of normalizing policy is being complicated by tensions with the German government over how much pain private-sector creditors should bear in tackling the Greek-led sovereign debt crisis.

“The ECB certainly is in no mind to make monetary policy based on the periphery,” said James Mason, senior research analyst at Roubini Global Economics in London. “We see them continuing to try to hike rates according to their plan.”

Separately, the Bank of England kept its benchmark rate at a record low of 0.5 percent today. Federal Reserve Chairman Ben S. Bernanke said this week the “frustratingly slow” U.S. recovery warrants sustained monetary stimulus, though the Fed will also “take whatever actions are necessary to keep inflation well controlled.”

Inflation Forecast

While euro-region inflation weakened to 2.7 percent in May from 2.8 percent the previous month after energy costs retreated, the ECB will probably increase its full-year estimate to 2.7 percent from 2.3 percent and also raise its growth estimate, said Silvio Peruzzo, an economist at Royal Bank of Scotland Group Plc in London.

“We do look for the expression ‘strong vigilance’ to be used, in the context of significant upward revisions to the staff macroeconomic projections,” said Julian Callow, chief European economist at Barclays Capital in London.

After a move in July, economists expect the ECB to raise rates again in October, taking the benchmark to 1.75 percent.

At the same time, the ECB and the German government are at loggerheads over their response to Greece. In a letter to Trichet and other finance officials this week, German Finance Minister Wolfgang Schaeuble said maturities on Greek bonds should be extended seven years to give the debt-wracked nation time to overhaul its economy.

Lehman Catastrophe

The ECB has opposed anything beyond a voluntary rollover of debt to avoid what European Union Economic and Monetary Affairs Commissioner Olli Rehn has called a “Lehman Brothers catastrophe.”

A swap offering investors terms that are “worse” than those of existing securities would constitute a coercive or distressed exchange, and be considered a default, Fitch Ratings said earlier this week. Trichet has said the so-called Vienna initiative approach, which would see bondholders commit to purchase new bonds after their existing holdings mature, was something “the ECB would consider appropriate.”

“The ECB is frustrated that there are these irrational politicians that they can’t control,” said Jens Sondergaard, an economist at Nomura International in London. Greece’s “doomsday scenario is that they default, they don’t get the payments and all bets are off.”

Unlimited Liquidity

With governments struggling to contain the region’s debt crisis, the ECB may keep providing lenders with unlimited liquidity. Banks in Greece, Ireland and Portugal have been reliant on central bank funding after lending dried up.

“You cannot separate monetary policy and the problems of the periphery completely, but you can to a certain extent,” said Holger Schmieding, chief economist at Joh. Berenberg, Gossler & Co. in London. “It’s likely they’ll indicate a rate hike and keep most of the other liquidity measures in place.”

Moody’s on June 1 downgraded Greece to Caa1 from B1, putting it on the same level as Cuba after policy makers considered asking investors to reinvest in new Greek debt when existing bonds mature. Greece said the move “overlooks” its commitment to meeting its 2011 fiscal target as well as an “accelerated” state-asset sale program.

Investors remain unconvinced. Greek 10-year bonds yield almost 16 percent and the country is the most expensive in the world to insure against default, at about 1,500 basis points, according to CMA prices. The yield investors demand to hold Greek 10-year bonds instead of benchmark German bunds widened for the first day in four yesterday.

The ECB is “desperate to avoid the debt crisis becoming a euro crisis,” said Steven Barrow, an economist at Standard Bank Plc in London. “The best way to do this is to prove its independence and raise rates. Do I think this is the best way? No. Do I know the ECB well enough to know that they will do it? Yes.”

To contact the reporters on this story: Jeff Black in Frankfurt at jblack25@bloomberg.net; Jana Randow in Frankfurt at jrandow@bloomberg.net.

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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