The Wall Street Journal

June 6, 2008

FRANKFURT — Despite a steadily weakening European economy, the president of the European Central Bank said rising inflation could prompt the bank to raise interest rates next month.

As expected, the ECB and the Bank of England kept their key short-term rates on hold Thursday, at 4% and 5%, respectively. But at a news conference, ECB President Jean-Claude Trichet said some on the bank’s 21-member Governing Council argued for a rate increase, and he added, “We could decide to move our rates a small amount in our next meeting in order to secure the solid anchoring of inflation expectations.”

Noting that rising commodity prices are likely to keep inflation “high for a more protracted period than previously thought,” Mr. Trichet indicated that any increase next month would likely be by a quarter percentage point. “I don’t say it’s certain,” he cautioned. “I say it’s possible.”

Mr. Trichet’s comments reversed the euro’s recent decline against the dollar, which began Tuesday when Federal Reserve Chairman Ben Bernanke made unusually pointed comments about the potential for the weak dollar to fuel inflation. The euro surged to $1.5599 late Thursday afternoon in New York, up from $1.5435 the day earlier, as traders priced in the likelihood of higher euro-zone interest rates. Higher interest rates usually attract investors to a currency.

The latest Trichet comments may complicate Mr. Bernanke’s defense of the dollar, given conventional wisdom that the dollar won’t recover until the Fed and ECB stop going in opposite directions. The Fed has now shifted from rate-cutting to neutral, a step toward harmony. But the ECB signal that it may move from neutral to rate increases reopens the trans-Atlantic gap, raising the odds that a weaker dollar may lead the Fed to tilt toward rate increases.

Markets expect a quarter-percentage-point ECB increase next month and another by year-end. Many economists who had forecast the ECB’s key rate would fall this year in the face of weakening growth switched course, but suggested the division among ECB policy makers and the bloc’s worsening growth prospects mean any increase would likely be a one-off gesture, not the start of a series.

“Our central view is now that the ECB will tighten policy by a quarter point next month,” said Philip Shaw, economist with Investec Securities in London. “It seems unlikely that Mr. Trichet would have been as explicit as he was were it not a real policy option.”

Soaring food and energy prices are pressing central bankers world-wide to rethink interest-rate strategies. The central banks of Indonesia and the Philippines raised their policy rates by a quarter-percentage point Thursday, to 8.5% and 5.25% respectively. New Zealand’s central bank Thursday kept its key rate steady at 8.25% to contain inflation, and signaled it is likely to begin lowering later this year as growth slows.

The Fed, which has lowered its benchmark short-term rate to 2% from 5.25% last summer, has signaled it is likely to keep its key rate on hold amid mounting inflationary pressures; markets speculate it could begin raising rates late this year.

Surging inflation also pushed investors to price in a quarter-percentage-point increase from the Bank of England by year-end. Inflation in Britain — which hit 3% in April, above the central bank’s 2% target — is likely to rise in coming months.

Many economists contend unchanged or lower rates remain more likely, particularly given the United Kingdom economy’s sensitivity to the housing sector. U.K. house prices fell 2.4% on the month and 3.8% on the year in May, the biggest annual drop since a 4.9% fall in April 1993, mortgage lender HBOS PLC said. Some economists warn the economy faces recession this year.

New ECB projections for growth and inflation highlight the bank’s dilemma. Euro-zone inflation this year is forecast around 3.4%, up from a March projection of around 2.9%. Next year, inflation should hover around 2.4%, up from March’s forecast of around 2.1% and well above the ECB’s aim of keeping inflation just under 2% over an 18-month to two-year period.

The strong euro, high oil prices and U.S. slump, meanwhile, should continue pressuring euro-zone growth. While a surprisingly strong first-quarter spurt boosted 2008 projections to around 1.8% from around 1.7%, Mr. Trichet cautioned against reading the surge as durable and forecast euro-zone growth would “trough” this year before recovering gradually. ECB staff growth projections for 2009 slipped to around 1.5% from about 1.8%. New data showed German manufacturing orders unexpectedly fell 1.8% in April from March, casting doubt on the health of Europe’s largest economy.