In this Oct. 1, 2010 file photo European Central Bank President Jean Claude Trichet pauses before speaking during a media conference after a meeting of EU finance ministers at the Egmont Palace in Brussels.
Tough talk on inflation from the European Central Bank suggests it may be considering a plan to raise official interest rates even as it keeps emergency funding support for commercial banks in crisis-hit countries.
ECB President Jean-Claude Trichet surprised markets on Thursday when, as the central bank kept its main refinancing rate at 1.0 per cent, he warned that risks to price stability in the medium term "could move to the upside".
He also made a point of recalling that the ECB raised rates in 2008, when it acted against oil price-fuelled inflation despite growing financial turmoil that developed into a crisis just a few months later with the collapse of Lehman Brothers.
The ECB ultimately was widely criticized for tightening policy as the region slid into recession. So Mr. Trichet's willingness to recall this episode, implicitly threatening to do the same thing again, was striking.
"If you talk tough on inflation, nobody can accuse you of being the soft central bank that gives in to political pressure," said Berenberg Bank economist Holger Schmieding.
Market expectations for an ECB rate increase this year or early in 2012 grew after Mr. Trichet's comments. Euro zone interest rate futures on Friday extended losses across the 2011/12 area, pushing up their implied yields.
The three-month Euribor rate - a mix of rate expectations and banks' appetite for lending - climbed to 1.006 per cent from 0.998 per cent, its biggest rise in one day since last Oct. 21.
Most economists agreed the chances of an ECB rate hike late in 2011 had risen significantly after Mr. Trichet spoke. Howard Archer at Global Insight put the probability of a hike before year's end at 70 per cent compared to 60 per cent before Mr. Trichet spoke. Investec's Philip Shaw said the odds were at least 70 per cent now versus 55-60 per cent late last year. ING's Peter Vanden Houte put the probability at 40 per cent now versus 20 per cent before Thursday's comments.
Mr. Trichet stressed on Thursday that the ECB's interest rate policy and the emergency measures it has put in place to support struggling banks on the periphery of the euro zone - in particular, offering them unlimited amounts of funds in money market operations - were independent of each other.
This appeared to point to a change of tack by the central bank. Last year, the markets generally expected the ECB to end its emergency measures before it started hiking rates - in fact, it began phasing out the emergency steps by letting special one-year money market operations expire.
In 2011 it may take the opposite tack: it may keep emergency steps in place - perhaps tweaking them slightly by, for example, offering banks much more cash than they need instead of unlimited amounts - while hiking rates to fight inflation in key euro zone states such as Germany.
"What's interesting is that although they've highlighted that in the past as a theoretical possibility, some of the comments Trichet made yesterday show the ECB clearly now accepts that that's probably going to be much more like a central case," said Societe Generale economist James Nixon.
The apparent change in the ECB's approach is probably due to trends in the euro zone's economic recovery and sovereign debt problems over the last several months.
Indebted economies and banks on the periphery of the zone have been hit harder than expected by austerity measures. The Bank of Portugal said on Tuesday that Portuguese banks would have to rely on the ECB for liquidity this year and next because they lacked access to the interbank market.
At the same time, economic growth in the core of the zone has been stronger than expected; Germany's economy rebounded last year at its fastest pace since reunification two decades ago, and wages are expected to rise considerably this year.
Meanwhile, expectations for interest rate hikes around the world have been mounting, partly because of inflationary pressure from surging food and fuel prices. Euro zone inflation jumped last month to 2.2 per cent, the first time in two years it has risen above the ECB's target of just below 2 per cent.
Many economists think a rise in the ECB's refinancing rate, which it uses to lend money to banks, would have little impact on economic growth or inflation if the central bank continued to pump large amounts of funds into the money markets via emergency measures. Reuters calculations show excess liquidity in euro zone money markets currently stands at about 50 billion euros.
Also, it is very unlikely that the ECB has made any firm decision on how it will proceed this year. Euro zone governments are now discussing a "comprehensive package" to address the euro zone's debt problems, which may be agreed by March; if this restores market confidence in banks, the ECB may be able to phase out emergency support steps at the same time as it raises rates.
But Mr. Trichet may want to send a signal to the markets now to avoid the kind of damage to the ECB's inflation-fighting credibility that other big central banks have been suffering.
In Britain, concern that the Bank of England has lost its grip on inflation - after it continually overshot its inflation target for the last several years - has risen to such a level that markets are increasingly pricing in an interest rate rise by this summer, even through growth remains weak.
In the United States, the Federal Reserve came under attack late last year from the U.S. Congress and foreign governments when it boosted its bond buying stimulus by $600-billion, which risks debasing the dollar as a reserve currency.
The ECB, which has itself been forced to compromise its conservative monetary principles during the euro zone crisis with a bond-buying scheme, may hope that by reinforcing its reputation as an inflation-fighter now, it may be able to avoid market volatility later this year.
"I think they want to maintain their credentials as an inflation-fighter...and to distance themselves a bit from the U.S. Fed, where the distinction between monetary policy and non-standard measures basically doesn't exist," said Mr. Schmieding.
Reuters