Inflation Fears Make Ecb Raise Rates

The European Central Bank raised its key interest rate by a quarter of a point to 2.5% yesterday, the second such rise in less than three months as it repeated its concern that a strengthening eurozone economy could stoke inflation.

The move took the cost of borrowing in the 12-nation bloc to its highest for three years although it remains far lower than the 4.5% level prevailing in Britain and the United States. Jean-Claude Trichet, the ECB president, described the new interest rate as "stimulative", a clear hint that the bank intends further monetary tightening into the summer.

Most analysts think rates could be at 3% by August and some think 3.5% by the end of the year is a possibility. "All the indications are that the ECB remains inclined to tighten monetary policy further over the coming months to contain inflationary risks," said Howard Archer, an economist at Global Insight.

The decision had been widely expected after hints from Mr Trichet in recent weeks. So well prepared for the move were financial markets that all 65 European economists polled in the run-up to the decision had predicted the move. The economic recovery in the eurozone has been led by the corporate sector, where exports have surged in response to a strong world economy. Business sentiment, particularly in the bloc's largest economy, Germany, is riding high. And there was fresh evidence yesterday that the strength in the industrial sector might be spreading to the domestic economy as German retail sales put on their biggest jump in January since euro notes and coins were launched in 2002. But that followed a big fall in December, and analysts said consumer spending was more likely to be improving steadily rather than leaping ahead.

The ECB is caught between a rock and hard place. On the one hand it is facing strong exports, rapid house price inflation in some member countries and inflation above its 2% ceiling. On the other, unemployment remains high at 8.3% while overall growth is sluggish due to a lack of robust consumer demand.

The zone's economy expanded by only 0.3% in the fourth quarter from the third, half the pace of the previous three months. The ECB, though, is convinced that the export-led recovery in the business sector will spill over into increased domestic demand, broadening and strengthening economic growth. Along with high energy prices, it feels inflation could be pushed further above its ceiling than it already is.

The ECB differs from the Bank of England in one key respect. It considers 2% to be a ceiling for inflation and becomes nervous when it goes above that level. The Bank of England's 2% target is symmetrical, meaning an undershoot is considered as bad as an overshoot. The US Federal Reserve has no fixed inflation target, seeing its job as keeping economic growth on track and inflation low. Eurozone inflation, although above its ceiling since last summer, fell back to 2.3% last month from 2.4% in January and most analysts expect it to fall back towards 2% in the coming months as the effect of last year's surge in oil and gas prices drops out of the comparisons. But the ECB regularly points to the strength of the corporate sector as proof that the recovery is becoming self-sustaining and does not need to be drip-fed cheap money any longer. A survey of purchasing managers in European industry this week showed output and exports doing very well, especially in comparison with British industry. And the ECB governing council is also concerned about house prices, which are booming in Spain and parts of France, although not at all in Germany. Yesterday the ECB raised its forecast for inflation this year and next, predicting it would remain above its ceiling with risks to the upside. It also slightly raised its growth forecasts to about 2% this year and next - solid but only around half the rate the US economy has managed in recent years with only modest inflation.

Some economists thought the ECB was running away with itself in its enthusiasm for dampening the economic recovery. "We expect the ECB to lift interest rates by a further 25 basis points at both its June and late August meetings, taking it up to 3%. We then expect it to return to the sidelines for an extended period as eurozone growth loses some momentum in reaction to an anticipated stronger euro and modest slowdown in global growth," Mr Archer said.

David Brown, economist at Bear Stearns in London, says the ECB was keen to move rates up fairly quickly because lower inflation and a downturn in growth he believes are coming later in the year will make it impossible for it to justify any further rises.

Miscounting the cost

It was a calculation shoppers faced at the checkout when Greece joined the euro. Take 1,000 drachma and convert them in your head into the new currency: first divide by three, then add a zero. What do you get? A rip-off, according to the European Central Bank

An ECB study shows that in those countries where the arithmetic of monetary union was fairly complex, such as Greece, Luxembourg and Belgium, food price rises were far bigger than where the conversion was simple, such as Germany

Michael Ehrmann, a researcher at the ECB, found that after monetary union countries could be divided into three groups. Inflation was generally lower for countries where shoppers had only a simple sum; it was also lower where the maths was so tricky that consumers armed themselves with pocket calculators. But in those countries where the conversion was neither very easy nor very hard, shoppers fared worst.

Price rises after the changeover were less in countries that required prices to be quoted in the euro and the old currency, helping shoppers to compare - a practice Slovenia began this week in anticipation of adopting the euro next year.