The ECB Pulls the Rate-Hike Trigger

In a widely expected move, the European Central Bank raises its benchmark interest rate 25 basis points, citing medium-term inflation risks

By BusinessWeek, Standard & Poor's, and Action Economics staff

Unlike the Federal Reserve, the European Central Bank has one policy mandate: maintaining price stability. And the ECB put its money where its mouth is on July 3, raising its benchmark interest rate 25 basis points to 4.25%. The Swedish Riksbank also raised its benchmark rate 25 basis points, to 4.5%, earlier in the day.

The ECB's move was widely expected by financial markets. Recent hawkish comments and the reaction to rising overall interest rates in the euro zone, along with stronger economic data, at least from Germany, had changed expectations to a rate hike in recent months.

"We expect another rate hike, perhaps in October, but not an extended string of them," wrote Standard & Poor's chief economist David Wyss in a July 3 note. "We expect sluggish growth in Europe over the next year, although probably better than in the U.S."

Keeping an Eye on Wages

In a press conference after the meeting, ECB President Jean-Claude Trichet said the rate hike was designed to counter medium-term inflation risks and prevent second-round effects—i.e., wage pressures. He said inflation risks increased since the June meeting and that vigorous credit growth confirms inflation risks. Still, data point to slowing but positive growth, according to Trichet, who added that the ECB will continue to monitor developments closely.

Trichet said he sees downside risks to growth—and upside risks to inflation. In the introductory statement, Trichet said downside risks to economic growth prevail. However, the ECB is partly playing down weak second-quarter data and Trichet stressed that first- and second-quarter data have to be taken together, and data have confirmed the ECB's growth expectations, which suggests that weak survey data have not led to a downward revision to growth.

At the same time Trichet stressed that inflation risks have increased and there is strong concern about the possibility of second-round effects, with the ECB watching wage deals with particular attention.

A Bit Less Hawkish?

The comments do not point to further rate hikes in the near future, said Action Economics in a posting on its Web site, but do leave the door open for additional tightening should inflation risks increase again. "This is broadly what we expected, but maybe less hawkish than many [market participants] had feared," said Action analysts.

The Euro fell vs. the dollar and other currencies after the widely expected rate hike. The market had fully priced in the ECB's rate hike, said Action, and with a long weekend looming in the U.S., barring fresh surprises from Trichet, profit taking may support the dollar for the near term.

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