Blog: The Hidden Dangers of the ECB Rate Hike

Last week the press conference of European Central Bank President Jean-Claude Trichet has left very little room for interpretation. It is now clear that a rate hike is highly likely at the April meeting. Why are they hiking?

It is possible to justify the rate hike based on fundamentals. Growth is slightly above trend, inflation above target, core inflation slowly creeping up from about 1 percent, credit is now showing more signs of pickup and money aggregates are reaccelerating.

Jean-Claude Trichet
Fabrice Coffrini | AFP | Getty Images
Jean-Claude Trichet

As an example, if we take a Taylor rule as a way to summaries the macroeconomic information we find that appropriate rates should be at 1 percent, but the trend is up: a rate hike would be needed soon.

Indeed, based on these elements we were expecting a rate hike in the third quarter, the ECB surprised us by a few months, but the move, from that fundamental point of is after all not such a surprise.

But this approach is valid in a "normal" world with a "normal" recovery. In our case there are at least two issues that remain: the unresolved banking crisis and the unresolved sovereign crisis. With that in mind, the rate hike can be viewed as very dangerous and possibly triggering an escalation of the crisis.

We think it is not a coincidence that the rate hike was announced three weeks before the head of states meeting that will decide on the extension of the EFSF. This is a very interesting move: the ECB has been recently involved in a many policy issues that were beyond its strict mandate.

This is for instance the case in the Greek or Irish bailout but also in terms of regulation. We think the rate hike is to a large extent a signal to the politicians that the ECB is unprepared to keep supporting the system: a "comprehensive solution" has to be found.

So the rate hike, we think, increases the probability of a better-than-expected outcome at the 24-25 March meeting because politicians no longer have the ECB safety net. But if, nevertheless, no agreement is found, the rate hike will make the crisis quickly difficult to manage.

The hike increases the probability of the tail risks: higher probability of a positive outcome at the meeting, but higher probability also of a crisis if nothing is decided. Interesting move, but a dangerous one too.

The author is Stephane Deo, head of European economic research, UBS