ECB FOCUS-Bank to signal inflation, not debt, the top threat

* ECB set to raise key rate for first time since July 2008

* Hike expected to be small at 0.25 percentage point

* Markets anticipate three such rate rises this year

* Periphery to cope despite weak banks, mortgage holders

* ECB may dodge issue of ending unlimited money market loans

By Paul Carrel

FRANKFURT, April 5 (Reuters) – By raising interest rates
this week as the euro zone’s weakest states struggle, the
European Central Bank is expected to signal it thinks inflation,
not debt, has become the biggest threat to the region.

Members of the ECB’s 23-strong Governing Council have hinted
repeatedly in the past few weeks that the bank will lift its key
refinancing rate at a policy meeting on Thursday for the first
time since July 2008.

With Greece and Ireland receiving international bailouts and
Portugal under heavy pressure to seek one, the rate hike will
carry risks. But the central bank believes it can tighten policy
slowly enough to avoid doing serious damage there.

It feels re-establishing its inflation-fighting credibility
is more important to avert an upward spiral of prices and wages.
Euro zone inflation rose to 2.6 percent last month, above the
ECB’s long-term target of just below 2.0 percent, and global oil
prices are hitting fresh 2-1/2 year highs.

Markets therefore expect a rise in the refi rate, which the
ECB uses to lend to commercial banks, of 0.25 percentage point
on Thursday, from the record-low 1.00 percent to which it was
cut during the global credit crisis in May 2009. They are also
pricing in two more such hikes by the end of this year.

“Against the background of a solid recovery, headline
inflation above 2 percent and increasing inflationary
expectations, it is hard to believe that a hike this week will
not be the start of a tightening or at least a normalisation
cycle,” said Carsten Brzeski, economist at ING.

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PERIPHERY

By many measures, the weak periphery of the euro zone, which
comprises Greece, Ireland, Portugal and Spain, is extremely
vulnerable to monetary tightening.

Credit Suisse estimated the periphery, accounting for 17
percent of the euro zone economy, would need a policy rate of
minus 4.6 percent under the Taylor Rule, a measure of where
rates should be given inflation and growth projections. Germany,
which has been booming, would need plus 4.5 percent.

Floating rate home mortgages are a big issue in Ireland and
Spain. In Spain, almost nine out of 10 mortgages are tied to the
12-month Euribor money market rate, which is up 0.5 percentage
point this year in anticipation of the ECB’s tightening, adding
500 euros to the annual cost of servicing a 100,000 euro loan.

An even bigger problem for some peripheral states is their
weak banking sectors; Ireland announced last week that its banks
needed 24 billion euros of fresh capital to regain stability.

IMPACT

Nevertheless, the impact of the ECB’s tightening will be
softened by the fact it has been telegraphed in advance, causing
market and mortgage rates to adjust ahead of time. This means
that when the hike is actually announced on Thursday, market
rates may move just a few hundredths of a percentage point.

And for many months, the ECB is likely to continue
supporting weak banks in ways other than low money market rates;
it is offering unlimited loans in its money market operations,
and threw a lifeline to Irish banks last week by suspending
collateral requirements for loans to them.

Berenberg Bank economist Holger Schmieding said the
periphery could cope with the gradual programme of rate hikes
envisaged by the ECB.

“This is 25 basis points from 1 to 1.25 percent — that is
next to nothing…If the ECB goes to 3 percent in one go —
okay, big problem. But going very gradually…this is not a real
problem.”

Berenberg estimated the annual impact on the Spanish economy
of a 0.5 percentage point rise in ECB rates at between 0.1 and
0.2 percentage point of GDP.

SOFTEN

The ECB may also soften the impact of this week’s refi rate
hike in other ways; these will be closely watched on Thursday to
gauge just how nervous the central bank is about inflation and
how much pain it thinks the periphery can bear.

The ECB’s overnight deposit rate, which acts as a floor for
short-term market rates, could be exempted from the hike and
left at 0.25 percent. This would make the refi rate rise largely
symbolic; actual money market rates might barely move.

ECB President Jean-Claude Trichet’s language at Thursday’s
news conference will also be important. In an effort to prevent
money market rates from rising much, he may insist this week’s
hike is not necessarily part of a series — though the markets
would probably not believe him.

If he does not describe rates after the hike as being
“appropriate”, and says the ECB is monitoring inflation “very
closely”, markets will expect another rise in coming months.

An important issue which Trichet may have to dodge at the
news conference, leaving markets to continue guessing, is when
the ECB will phase out its offers of unlimited loans. These were
introduced as an emergency step but have now become a liability,
injecting so much money into banks that the ECB cannot
effectively control market rates.

Last month, euro zone official sources told Reuters that the
ECB was close to creating a new liquidity facility that would
support weak banks in Ireland and elsewhere, helping it
eventually to phase out unlimited loans.

However, disagreements within the Governing Council over how
much aid the central bank should provide to countries have
caused that plan to be suspended. In the absence of an
alternative to unlimited loans, Trichet will probably be unable
to say anything explicit about ending them.

(Editing by Andrew Torchia)

ECB FOCUS-Bank to signal inflation, not debt, the top threat