ECB Ready to Up Rates to 4%, Future Timing Is Unclear

The European Central Bank is poised to raise interest rates to 4.0% on Wednesday, the highest level in six years, with investors anxious for clues on the pace of future hikes.

A quarter percentage point rise would mark a doubling of euro zone rates in 18 months. Strong warnings on inflationary risks from ECB policymakers in recent weeks have left financial market dealers virtually certain that rates will reach at least 4.25% this year.

The ECB announces its decision in the European morning session followed by ECB President
Jean-Claude Trichet's news conference.

Business activity is expanding robustly, confidence is high and unemployment has fallen to its lowest level on record in the 13-nation euro zone, brightening prospects for consumer spending to surge, supporting growth this year at 2.5% or higher.

With the economy powering ahead at the fastest pace this decade, the threat is rising that businesses will run out of operating capacity and start pushing up prices, while workers will demand higher wages.

"Trichet is going to leave no doubt the ECB is not done yet," said Lena Komileva, G7 economist at Tullett Prebon.

But uncertainties over the resilience of the global economy to a housing-driven downturn in the United States and a shaky Chinese stock market cast doubt over just how quickly the ECB will proceed.

This confronts Trichet with a tricky balancing act of conveying that rates will rise without clear guidance on timing.

"He will probably want to say the ECB will be fairly flexible in how they will respond to inflationary risks," said Komileva. "He will signal they will rise further but without saying when."

A critical component to that message will be updated staff economist forecasts, which Trichet releases during his news conference. The ECB already has warned that inflation, which has held below 2% for nine months now, could accelerate later this year, especially with oil prices back to $70 a barrel.

In a Reuters poll in mid May, analysts forecast inflation edging up to 1.9% this year and 2% next year, from midpoints of 1.8% and 1.9% that were projected by the ECB staff in March. This would set the stage for a hawkish policy message.

"If, as we expect, the new staff projections show CPI inflation breaching the ECB target in 2007 and 2008 for the eighth and ninth year in a row, the Council will naturally be tempted to play it safe," said Javier Perez de Azpillaga, economist at Goldman Sachs, which sees risks tilted toward the next ECB hike after June coming in August.

Key Words

The precise wording of the Governing Council's policy statement, read out by Trichet at the start of his news conference, also will be closely parsed for clues on the determination of the ECB to move aggressively on rates.

If the ECB drops the adjective "accommodative" for rates, that would signal they are getting closer to a peak.

As for the timing of hikes, that could get fuzzier. Over the past 18 months, the ECB has used a series of code words -- watching inflation "very closely" meant a hike was at least two months away, while "strong vigilance" meant next month.

With interest rates at more normal levels, most analysts expect the ECB to start feeling its way forward, with the timing of future moves dictated by the strength of economic data.

ECB Governing Council member Axel Weber hinted at this recently. He said code words are "probably the least helpful part of the communication" and would prefer investors to rely on economic and monetary analysis to gauge the path ahead.

But the phrase "monitoring risks very closely" may stay, to show the ECB remains on high inflation alert, ready to act at any time.