European Central Bank Hikes Interest Rate to 6-Year-High

The European Central Bank raised interest rates to a near six-year high of 4 percent on Wednesday and showed its readiness to hike again to combat inflationary dangers in a strongly expanding economy.

However, ECB President Jean-Claude Trichet gave limited guidance over how soon the next rate increase would come, or how much tightening remains in store, leaving markets uncertain over the precise course ahead.

The quarter-point increase, which had been widely expected, marks a doubling of euro zone rates in 18 months and brings ECB rates to their highest level since September 2001.

Trichet said in the Governing Council's monthly statement that monetary policy was "still on the accommodative side" after the increase.

This wording suggests the ECB has not yet finished with the process of raising rates and helped to send yields on benchmark 10-year euro zone bonds to a new high above 4.5 percent.

"Trichet's tenor remains hawkish," said David Brown, chief European economist for Bear Stearns.

Yet several elements softened this stance. Inflation risks would be monitored "closely," rather than "very closely," the wording it used after hikes the past 12 months. This usually suggests at least three months before the next move, though Trichet said the ECB makes no promises ahead of time.

European debt prices rallied and the euro currency slipped as dealers gauged that the ECB may be turning more flexible than the lock-step rate hikes delivered every two or three months.

"The overall tone of his comments leaves some place for discussion about the timing of the next move," said Kenneth Broux, analyst at LLoyds TSB Corporate Markets.

Euribors are now pricing a two-thirds probability for rates to reach 4.25 percent in September, down from over 70 percent before the meeting. Rates at 4.5 percent by June 2008 likewise slipped to two-thirds certainty from nearly 100 percent earlier.

At 4 percent, ECB rates are now viewed by most economists as having reached neutral territory, which neither stimulates growth nor restrains inflation. Hence it surprised some analysts that the ECB chose to described rates as still accommodative, yet to drop the phrase that rates were "moderate."

Additionally, ECB staff projections for inflation in 2008 were kept at a 2 percent midpoint within a range, the same as in March. The euro currency slipped below $1.35 on that unchanged forecast, which might imply a less aggressive round of rate hikes ahead.

In a sign of uncertainty, the Reuters poll conducted after the meeting showed economists firming their views on ECB policy, with 52 out of 62 expecting a September hike and an 80 percent probability of 4.25 percent rate by year end, up from 75 percent a week earlier.

This view was supported by an upward revision to the inflation forecast for this year to a 2 percent midpoint from 1.8 percent, reflecting higher oil prices, which have returned to around $70 a barrel recently. GDP growth also was revised upward slightly to 2.6 percent this year from 2.5 percent, but for 2008 the growth was nudged downward to 2.3 percent from 2.4 percent.

MIXED MESSAGE

Yet for some analysts, Trichet cast doubt over September move when he said at the moment he sees no reason for the ECB to meet in the holiday month of August when Governing Council members usually hold a teleconference.

Since the central bank prides itself on carefully preparing markets a month ahead through its monthly news conference for a pending rate hike, this caused question whether September could be receding.

Julian Callow, European economist for Barclays Capital, said the ECB also seemed to be sending mixed messages by calling policy accommodative but no longer saying rates were "moderate" and refusing to ratify market rate expectations.

"Perhaps it wants to keep its powder a bit dry, which is why it might not raise rates in September. That said, much will depend on how the economy - and inflation risks - evolve during the months ahead," he said.