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ECB to Shrug Off Periphery Concerns, Raise Rates

The European Central Bank is expected to raise rates by 25 basis points on Thursday, as indicated in its June press conference, despite ongoing concerns over the euro zone's periphery.

European Central Bank
European Central Bank

Economists who spoke to CNBC.com shared the consensus view that the ECB would follow through with President Jean-Claude Trichet's use of the code words "strongly vigilant" last month and hike rates by a quarter of a percentage point to 1.50 percent.

The bank has already raised its rates once, in April, as it looks to normalize its monetary policy post-crisis and move interest rates away from the historic lows of one percent that it held during the years of the downturn.

However, a perceived worsening of the sovereign debt crisis in Southern Europe, including the downgrade of Portuguese debt to "junk" by Moody's on July 5, has led some analysts to suggest that the ECB might postpone its hike.

The ECB is known to be reactive to inflation concerns, and with inflation in the euro zone estimated at 2.7 percent - above the ECB's target of 2 percent – the bank is likely to hold firm to its planned raise, analysts said.

As Stephane Deo, European economist at UBS, wrote in a research note on Wednesday, the ECB does not look at individual countries, rather at the aggregate of the euro zone, and so it is unlikely to react based on concerns over Greece or Portugal.

Research earlier in the week from HSBC showed that the Eurosystem – the ECB and euro zone central banks – could stand to lose 23 billion euros ($32.9 billion) on its bond holdings in peripheral countries, in the event of a 50 percent haircut on Greek, Portuguese and Irish debt.

The balance sheet of the Eurosystem has expanded less than those of the UK and US central banks, HSBC economist Astrid Schiller wrote, but the potential for reputational loss is higher still.

There is a legal concern too, Schiller wrote, should the rating agencies downgrade Greek debt, and should the ECB continue to use that debt as collateral.

"If the Eurosystem accepts collateral that rating agencies, or any other institution deem to be in default, there is the possibility that some (be it a euro zone citizen, a financial market participant or an academic) will consider the Eurosystem to be in breach of Article 123 of the European Treaty, which prohibits the financing of government deficit," she wrote.

A default may also presage the need for even more intervention in financial markets, which would put legal, financial and reputational pressure on the euro system, she added.

"Overall, it seems to us this is a typical case of ‘You can’t have your cake and eat it’. When the financial crisis threatens to destabilize the (global) economy, observers are quick to call for resolute Eurosystem action," Schiller said.

"However, once this has happened, people question the quality of the Eurosystem’s balance sheet."