ECB holds rates, expected to signal July rise

By Paul Carrel

FRANKFURT, June 9 (Reuters) – The European Central Bank held interest rates on Thursday and is expected to signal a rise in July to tackle price pressures in the euro zone, where it faces pressure to help clear the way for a new Greece bailout plan.

The ECB kept its main refinancing rate at 1.25 percent, but is expected to use higher staff inflation forecasts, to be published during the post-policy meeting news conference, as justification for higher rates to come — probably starting with a 25 basis point rise to 1.50 percent next month.

In the post-meeting news conference, ECB President Jean-Claude Trichet is expected to say the bank will exercise “strong vigilance” over price pressures, using a phrase that in the past signalled a hike was a month away.

He used that code in March to flag a rate rise in April to 1.25 percent from 1.0 percent — the ECB’s first tightening in two years.

“Today would have been too early for the ECB to raise rates,” said Berenberg economist Holger Schmieding. “It would have been too soon after the April rate hike, it would have signalled a very aggressive ECB rate stance.

“We expect the ECB to signal a rate hike for July but to leave the outlook for rate policy thereafter deliberately open so as not to trigger a major rise of the euro or spook the markets in any other way,” he said.

All 74 economists polled by Reuters had expected the ECB to leave rates unchanged at 1.25 percent. [ECB/INT] Earlier on Thursday, the Bank of England kept its key interest rate unchanged at a record low 0.5 percent. [ID:nLAC005850]

Firming cost pressures — euro zone producer prices rose by more than expected in April and headline inflation was 2.7 percent, well above the ECB’s 2.0 percent target ceiling — mean it is likely to signal a rate rise in July.

ECB staff projections are likely to be raised, both for inflation and economic growth. In the last set of forecasts, published in March, the ECB forecast inflation of around 2.3 percent this year and 1.7 percent next.

 

GERMAN INITIATIVE

The ECB is caught up in high-stakes manoeuvring between financial markets, euro zone governments and the International Monetary Fund over who pays to avoid Greece becoming the euro zone’s first state insolvency.

Germany is pushing for private sector involvement.

In a June 6 letter sent to the heads of the ECB, IMF and his euro zone counterparts, German Finance Minister Wolfgang Schaeuble demanded a “quantified and substantial” contribution from bondholders as part of any new Greek package.

The ECB has not yet given an explicit, public reply to this proposal but Trichet has said he would be prepared to accept a scheme in which financial institutions in Europe were asked to maintain their level of outstanding credit to Greece.

The ECB still opposes a cut in the principal of the debt, which would mean default and would hit the central bank hard because it has bought about 45 billion euros ($66 billion) of Greek government bonds since last year in an effort to calm markets.

The ECB also wants Greece to meet its commitments to improve its fiscal position and for other euro zone governments to help with aid, and has resisted pressure to help Athens by reactivating its now dormant bond-purchasing programme.

However, the central bank is warming to the idea of having private investors share the burden of rescuing Greece, potentially clearing the way for a debt swap. [ID:nLDE7570KR]

Trichet, whose term as ECB president expires at the end of October, will be pressed for a more detailed response to Schaeuble’s letter at his post-meeting news conference.

“The pressure for private sector involvement now seems so intense that it cannot be resisted,” J.P. Morgan economist Greg Fuzesi wrote in a research note.

 

FUNDING HELP

While it is expected to flag a July rate rise, the ECB will be careful not to withdraw support to the economy and banking system so fast as to stall the recovery or endanger banks’ ability to cope with limited liquidity.

Fears that the debt crisis might spill over to the banking system and the fact that banks in bailed-out euro zone states remain shut out of credit markets, will probably stop the ECB reintroducing liquidity auctions.

The ECB started handing out unlimited cash in all liquidity operations in October 2008, after the collapse of investment bank Lehman Brothers intensified financial market turmoil.

Since then, it has scrapped the ultra-long six- and 12-month liquidity operations and moved back to auctions in three-month tenders last year. However, it returned to full allotment for those operations quickly after the Greek crisis intensified.

Executive Board member Lorenzo Bini Smaghi said last week the central bank might not be ready to announce its plans this week, suggesting it may make a last minute decision at its July 7 meeting. The ECB has committed to keeping tenders on an unlimited funding basis until at least July 12. (Editing by Ruth Pitchford/Mike Peacock)