ECB Holds Rates, Stays in Wait-and-See Mode

The European Central Bank kept rates unchanged at 4% as widely expected Thursday, waiting to see how the credit crisis will affect the euro-zone economy.

The Bank of England also held rates steady at 5.75%, their highest level in six years, with economists predicting that rates will finish the year at this level.

Before August's credit crisis began, the markets expected the ECB to hike its main refinancing rate by 0.25 percentage points in September -- bringing it to 4.5% by the end of the year -- to stick to its main objective of fighting inflation.

In a speech after the decision, Trichet said inflationary pressures were still there.

"The overall continued vigor of money and credit expansion points to upside price risks," Trichet said, adding that he expected inflation to remain above 2% in 2007 and in early 2008.

Economists said Trichet's speech signaled the bank was likely to remain on hold, noting that a major change was the fact that monetary policy was no longer described as "on the accommodative side." Instead, Trichet said "monetary policy stands ready to counter upside risks to price stability."

This means the ECB is likely to remain on hold "at least until the second half of 2008, although it will probably keep its underlying tightening bias throughout this period," ING Bank's Mathieu Verougstraete wrote in a market note.

Verbal Discipline Needed for Euro

Asked by CNBC's Frankfurt correspondent Silvia Wadhwa if the euro's exchange rate worried him, Trichet said: "When we take monetary policy decisions, we take all parameters into account. The exchange rate is a very important question which calls for verbal discipline."

Pressure has been mounting on the ECB to help euro-zone exporters, starting with the blunt remarks of French President Nicholas Sarkozy - whose country exported 20 billion euros ($28.4 billion) worth of luxury items last year - and followed by more veiled requests from Italian Prime Minister Romano Prodi and others.

Economists said the strong euro has partly offset inflationary pressures but they were still high.

"We have high oil, food and raw materials prices," Fritz Breuss, a professor at the Research Institute at Vienna University, told "Power Lunch Europe." But he said core inflation, excluding volatile oil and food prices, had been slower.

The crisis in the financial markets was a "special case" and it may bring about a change in the ECB's monetary policy next year, especially because the strong euro was starting to hurt businesses, Breuss added.

Recent data suggests the euro-zone economy may be starting to feel the effects of the credit crunch, with service industry growth falling in September to the lowest level in a little over two years.

"We should look at decreasing interest rates in the euro area in the next months ... this would help our exchange rate," he said.

Bank of England Keeps Rates on Hold

The Bank of England kept interest rates on hold at a six-year high of 5.75% Thursday, as it waits to see how a global credit crunch will affect the U.K. economy.

The bank issued no statement after the decision and economists say it will stay on hold, at least for this year.

AP Bank of England Governor Mervyn King

"Until (the BoE) sees concrete evidence that the economy is slowing it's not going to respond," Alan Clarke, UK economist at BNP Paribas, told "Power Lunch Europe."

Rate cuts may follow next year because of signs of economic weakening like a softer labor market.

"We suspect the policy rate could be down to 5% and possibly even lower in the second half of 2008," ING Bank's James Knightley said in a market note.

"This suggests significant downside risks for sterling, particularly versus the euro, given that the ECB is unlikely to ease monetary conditions in the Eurozone anytime soon," he added.

But Mitul Kotecha, from Calyon, told "Power Lunch Europe" that the bank's decision was not likely to have a significant impact on the currencies.

"We've already got it priced in, in the U.S.," he said.

Kotecha added that the ECB, which is due to announce its decision at 12:45 pm London time, is facing a tough decision because the euro has been appreciating fast.

"The euro still looks overvalued from our perspective," he said, adding that he expected rhetoric against a strong euro to intensify.

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