Trichet Says ECB May Raise Rates, Show ‘Strong Vigilance’

European Central Bank President Jean-Claude Trichet said the ECB may raise interest rates next month for the first time in almost three years to fight mounting inflation pressures.

An “increase of interest rates in the next meeting is possible,” Trichet told reporters in Frankfurt today after the central bank set its benchmark rate at a record low of 1 percent for a 23rd month. “Strong vigilance is warranted,” he said, adding that any move would not necessarily be the start of a “series.”

The comments surprised economists and investors, most of whom hadn’t expected the ECB to raise rates before August. The euro jumped more than 0.9 percent to $1.3976, the highest since November. German government bonds, a benchmark for Europe, dropped, sending the yield on the two-year bund 18 basis points higher to 1.713 percent.

Trichet is signaling tighter policy at a time when Ireland and Greece are struggling to cope with the terms of last year’s European Union bailouts and governments are hammering out a plan to draw a line under the crisis. The danger is that raising rates to tackle inflation will exacerbate the financial tensions that still run through euro region bond markets.

‘The ECB Will Hike’

“The ECB will hike rates by 25 basis points in April and I wouldn’t be surprised to see another increase in September or October,” said Natascha Gewaltig, chief European economist at Action Economics in London, who forecast before today’s meeting that the ECB would tighten policy in the first half. “Inflation expectations are picking up, that’s a clear signal for rate setters.”

The ECB is concerned about so-called second-round effects, when companies raise prices and workers demand more pay to compensate for soaring energy and food costs, entrenching faster inflation. Crude oil surged above $100 a barrel last week amid political tensions in the Middle East and North Africa. Euro-area inflation accelerated to 2.4 percent last month.

“There is a strong need to avoid second-round effects,” Trichet said, calling for moderation from wage and price setters. The ECB is “prepared to act in a firm and timely manner.”

He signaled any rate move would likely be a quarter-point step, saying a bigger increase would not be appropriate in his view. A rate increase in April would put the ECB ahead of its U.S. and U.K. counterparts.

Federal Reserve

Federal Reserve Chairman Ben S. Bernanke said on March 1 that the surge in oil and other commodity prices probably won’t cause a permanent increase in broader inflation and repeated that U.S. borrowing costs are likely to stay near zero.

The Bank of England may be moving closer to raising its key rate from 0.5 percent, with three of its nine policy makers voting for an increase last month.

China on Feb. 8 raised rates for the third time since mid-October to curb inflation and prevent its economy from overheating.

The ECB today raised its inflation and growth forecasts.

Inflation will average 2.3 percent this year, up from a December forecast of 1.8 percent and in breach of the ECB’s 2 percent limit, before slowing to 1.7 percent in 2012, the projections show. The 17-nation euro-area economy will expand 1.7 percent this year and 1.8 percent next, up from previous forecasts of 1.4 percent and 1.7 percent, according to the ECB.

Debt Crisis

At the same time, Europe’s debt crisis is far from over, with politicians yet to agree on new steps to bolster the region’s rescue fund.

While governments are cutting spending to rein in deficits, risk premiums for Spain, Portugal and Italy have increased since a Feb. 4 EU summit that failed to endorse an economic competiveness plan proposed by Germany and France as a condition for aid.

“The ECB is preparing to raise rates too early,” said Julian Callow, chief European economist at Barclays Capital in London. “It should give the euro-area economy more chance to get on a sustainable footing, particularly since it is still too early to tell how the intense fiscal consolidation in many countries will affect demand this year and next.”

Trichet said the ECB will keep its emergency liquidity measures in place at least through the end of the second quarter to help soothe tensions in financial markets. The ECB is lending banks as much money as they want at its benchmark rate for periods of up to three months.

Liquidity Measures

“Trichet was much more cautious on the liquidity front,” said Marco Valli, an economist at UniCredit Group in Milan. “This confirms that standard and non-standard measures in the ECB’s strategy are very much separated. We think that rate hikes throughout 2011 will take place with full allotment still in place, at least for weekly operations.”

The ECB last raised rates in July 2008, just before the global financial crisis intensified. It was then forced into an unprecedented series of rate cuts to prop up the economy. That’s unlikely to happen this time, said Jens Sondergaard, an economist at Nomura International in London, who now expects three quarter-point rate increases from the ECB this year.

“The sovereign debt crisis would have to intensify significantly for the ECB to delay the start of the rate hiking cycle,” he said. “The message from today’s meeting is clear: with inflation risks crystallizing, the ECB stands ready to act in April.”

(Updates with economist comments from fourth paragraph.)
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