ECB Expected to Raise Interest Rates This Week

The European Central Bank is facing a true dilemma with its upcoming interest rate vote. On the one hand, the Bank is cognizant of the rising rate of inflation in certain economies comprising the 17-member Eurozone of countries, while on the other, it is aware of the pressures the so-called “periphery” nations face as they deal with the ongoing credit crisis.

For ECB President Jean-Claude Trichet and the governing council which votes on interest rate actions, the task before them is straight-forward enough – implement an interest rate policy that meets the needs of the Eurozone. The trick however, is understanding exactly what meets the needs of the entire region.

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Here’s the thing. Inflation is growing at an alarming rate in some Eurozone economies and under ordinary circumstances, the course of action would be simple – hike rates to make borrowing more expensive. This standard central bank response is the tried and tested method of reigning in spending and reducing the rate of growth back to a more acceptable level.

The problem confronting the ECB of course, is that inflation is not uniform across the Eurozone and while some countries are experiencing rapid growth, others are struggling with high debt and weak growth. Increasing interest rates at this time could further reduce economic activity and potentially tip countries such as Spain and Portugal into insolvency.
Because raising interest rates increases the risk of default for those countries already on the bubble, the Bank has no choice but to formulate a policy that deals with the needs of all member nations when it makes its announcement on Thursday.

Actually, no, the ECB must avoid the temptation to be all things to everyone.
By attempting a weak, overly-accommodating policy, the Bank will simply worsen the situation across the board. For those countries with inflation approaching twice the targeted level of two percent annual growth, a strong message is needed now to show the bank is serious about tackling inflation. Anything less will simply allow inflation to continue. After all, when forced to endure bitter medicine, best to take enough to do the job properly rather that taking half-doses over an extended period.

For the peripheral nations, it is true that a rate hike will be painful and could even force the more perilous nations to default. However, if Portugal and Spain are indeed fated to go the way of Greece and Ireland and are ultimately forced to appeal to the EU for financial assistance, then let’s cut to the chase and do it now and eliminate further speculation. Allowing the entire economy to suffer rather than limiting it to the weakest economies is a fool’s game that will actually lead to greater overall suffering, extended over a longer period of time.

It appears that the ECB will opt for the decisive action route when it releases its updated interest rate policy this Thursday. Last month, a statement from the Bank warned that “strong vigilance” was needed to deal with inflation and Trichet repeated the stance in subsequent comments. Thus, it seems that a rate hike is very likely later this week and this is already leading to speculation of a strengthening euro.

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