Europe interest rates up but its economy may be cooling

By Christian Vits  |   2008-7-4  |     NEWSPAPER EDITION

The European Central Bank raised interest rates to a seven-year high to fight inflation even as economic growth cools.

The ECB's Governing Council, meeting in Frankfurt, increased the benchmark lending rate by a quarter point to 4.25 percent yesterday, as predicted by all but one of 58 economists in a Bloomberg survey.

Policy makers say they're worried that the fastest inflation in 16 years will develop into a wage-price spiral as workers demand more pay to compensate for rising costs. The risk is that higher interest rates deepen Europe's economic downturn. France and Spain have already said that the ECB may not be paying enough attention to the growth outlook.

"The ECB is choosing the lesser of two evils," said Rainer Guntermann, an economist at Dresdner Kleinwort in Frankfurt. "We fear that oil prices and inflation will create the need to raise interest rates further."

Investors have fully priced in another quarter-point rate increase to 4.5 percent by the end of the year and most expect a third step by March, Eonia swap contracts show.

Central banks from Russia to Brazil are raising rates as inflation replaces the global credit crunch as their biggest concern. Indonesia moved yesterday for the third time in as many months and Sweden lifted its benchmark rate to a 12-year high.

"If we're not decisive, there's a risk of inflation exploding," ECB President Jean-Claude Trichet told the German newspaper Die Zeit.

Record food and energy prices pushed inflation in Europe to 4 percent this month, twice the ECB's 2-percent limit. Producer prices jumped a record 7.1 percent in May from a year earlier.

Oil prices have doubled over the past year and breached US$145 a barrel for the first time yesterday.

Still, with faster inflation sapping purchasing power and further damping the growth outlook, Trichet said last month that some of the ECB's 21 policy makers were against raising rates.

Executive Board member Lorenzo Bini Smaghi said on June 17 that one quarter-point rate increase "should be enough" to rein in inflation. Spain's Miguel Angel Fernandez Ordonez has expressed concern about "contractionary trends" in his economy, which grew at the slowest pace in 13 years in the first quarter.

"I am not convinced it is prudent to significantly raise interest rates at this stage," French Finance Minister Christine Lagarde said.