Europe could be set for interest rate hike

FRANKFURT - The European Central Bank is expected to raise interest rates to 3.0 per cent tonight (NZ time) in what would be the fourth increase since December, as it tries to rein in inflation risks while keeping the euro zone economic recovery on track.

All 60 economists polled by Reuters last week expected the ECB to tighten credit costs by a quarter percentage point, speeding up the pace of rate rises against a backdrop of firming employment and solid business profits.

An announcement that the 18 Governing Council members will meet in person in Frankfurt at 0700 GMT, instead of holding their usual summer teleconference, set the seal on the prospect for rates to rise to their highest level since December 2002.

But the prospect of budget belt-tightening in Europe in 2007 and a weaker US economy have fanned doubts about growth next year and how much further the ECB raise rates before pausing.

Economists will scrutinise comments by President Jean-Claude Trichet at his 1230 GMT news conference, which follows the rate decision at 1145 GMT, for hints on how the ECB will manage what it calls the "progressive withdrawal of monetary accommodation".

A slim majority of analysts polled by Reuters predicted the ECB would squeeze in two more increases by the end of the year, taking benchmark rates to 3.5 per cent. The remainder expected the central bank to stop at 3.25 per cent.

Rabobank economist Elwin de Groot saw rates at 3.25 per cent in October as a sure thing, given the inflation outlook. "Beyond that point there's likely to be somewhat more uncertainty about further tightening but we believe that the ECB hasn't finished yet and that we are likely to see a hike again in December," he said.

The Bank of England is expected to hold its key rate steady on Thursday at 4.5 per cent, although worsening inflation has cast doubt on how long that can last.

Inflation in the euro zone has been at 2.5 per cent, well above the ECB's 2 per cent ceiling, for the last three months and turmoil in the Middle East is likely to keep oil prices under upward pressure.

The Eurozone Purchasing Managers Index showed manufacturers grew bolder about passing on their costs in July, and rapid money and credit growth adds to longer term price risks.

Corporate pricing power is likely to be bolstered by strong profits, with firms including Dutch telecoms group KPN and German carmaker Volkswagen reporting better-than-expected results in the second quarter.

But Deutsche Bank pointed to uncertainties about the sustainability of economic growth and higher inflation, while the International Monetary Fund repeated calls for the ECB to be cautious on rate moves.

BNP Paribas economist Luigi Speranza said the ECB had to juggle downside growth risks from a slowing global environment, and increasing price pressures.

"These are two offsetting factors, I think they are more worried on inflation and more worried that global growth could be a downside risk," he said. "I'd be very interested to see ... where they stand in terms of which is more important."

A deteriorating outlook in 2007 would bolster the case for the ECB to raise rates now, while the economy is growing close to trend, and then pause.

The ECB last increased rates in June, following a pattern of one move every three months. Analysts said that shifting to one rise every two months meant the central bank might also have to abandon the three-stage system of code words it has so far used to signal rate hikes.

Trichet flagged this week's expected rate rise by saying at last month's news conference that the ECB would "exercise strong vigilance" on inflation risks, which has been the form of words used in the run-up to past rate increases.

"We would not be surprised if this kind of traffic light system was ditched tomorrow," Speranza said.

- REUTERS