ECB Raises Rates, Hoping to Curb Inflation While the Euro Falls

The European Central Bank surprised the financial world Thursday by hiking interest rates a quarter of a point to discourage inflation in the 11 nations using the region’s common currency, the euro.

Most economists welcomed the move--the Frankfurt-based bank’s seventh boost in key rates in less than a year--as appropriate in view of record oil prices and the euro’s continuing weakness despite a successful international effort two weeks ago to prop up the currency. But the euro largely shrugged off the move, ending the day down about half a cent at 86.9 cents in New York trading.

While the ECB decision was unexpected at this week’s meeting of the bank’s governing board, another increase in the interest rate had been expected by the end of the year.

The bank raised the refinancing rate--the rate charged commercial banks for buying back short-term securities--to 4.75%. It also added a quarter of a point to the overnight deposit rate to lift it to 3.75%.

“Today’s decisions continue to aim at ensuring that upward pressures on consumer prices stemming from oil prices and the foreign exchange rate of the euro do not translate into more permanent inflationary tendencies,” ECB President Wim Duisenberg told journalists after announcing the rate hikes.

Inflation in the euro zone exceeded the bank’s self-imposed 2% limit for the three months ended in August, and the trend is believed to have intensified last month largely because of soaring oil prices.

Oil is priced in U.S. dollars and has been averaging $35 a barrel in recent weeks--almost $10 more than the euro-zone economies budgeted. It has slipped lately to $30.

The need to exchange more dollar reserves than expected for fuel imports has put even more pressure on the beleaguered common currency, which has lost 25% of its value against the dollar since it was launched in January 1999.

The international intervention Sept. 22, when nations of the Group of 7 joined euro states in cashing in dollar reserves, bolstered the common currency at the time and allowed it to weather last week’s decision by Danish voters against joining its European Union colleagues in adopting the euro. But after rallying from 86 cents to 90 cents, the euro’s value has been eroding in the past few days and had dropped below 87 cents again by the time of the rate-hike announcement.

With confidence in the troubled currency flagging and oil prices holding stubbornly high, Duisenberg said the bank felt another rise in interest rates was “consistent” with the economic outlook. He added that the ECB will continue to closely monitor the euro’s fate against the dollar and intervene again when “appropriate.”

“The decision was desirable and correct,” Deutsche Bank’s chief economist, Norbert Walter, said, adding that he had expected another rate hike in the fourth quarter but not so soon.

“It was surprising, but in order,” said Klaus Friedrich, chief economist at Dresdner Bank. “It is in accord with the economic outlook and the actual dangers of inflation in the euro region.”

Some fears were expressed in labor circles that the latest ECB intervention was an overreaction that could slow growth in the euro zone, expected to reach 3.5% this year. Although that would be the region’s best performance in more than a decade, it still pales next to the 5% growth forecast in the United States. The weak euro is blamed on that disparity, as investors see better profit prospects across the Atlantic.

By raising interest rates, the ECB aims to deter inflation and bolster the currency. But the action also could slow economic growth by making it more expensive for business and industry to borrow money to hire new workers and step up production.

“Out of excessive fears of inflation, the European Central Bank has signaled fatal consequences for economic growth and the labor market,” warned Ursula Koniter, a deputy leader of Germany’s DAG union, representing public workers.

But in a press release issued after the ECB action, the German Trade and Industry Council applauded the rate hikes, noting that continued high oil prices are likely to keep the euro’s value down.

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Rate Rise

The European Central Bank unexpectedly raised the refinancing rate Thursday by a quarter of a percentage point to 4.75%.

European Central Bank refinancing rate

Sources: European Central Bank, Associated Press