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ECB struggles to decide whether interest rate shall be increased later this Spring

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European Central Bank President Jean-Claude Trichet signaled he’s prepared to raise interest rates if needed to fight inflation even as leaders struggle to contain the region’s sovereign debt crisis.

“We are permanently alert, we are never pre-committed not to move interest rates and our level of interest rates is designed to deliver price stability,” Trichet said at a press conference in Frankfurt today. At the same time, the benchmark rate, which the ECB left at 1 percent, is still “appropriate.”

Trichet is trying to keep a lid on inflation without roiling financial markets spooked by the euro region’s fiscal crisis. While increases in consumer prices exceeded the ECB’s ceiling for the first time in more than 2 years in December, higher interest rates would saddle debt-laden countries such as Ireland, Greece and Portugal with still higher borrowing costs. The yield on German two-year bonds jumped 12 basis points to 1.103 percent after Trichet’s comments. The euro rose to $1.3279 at 3:32 p.m in Frankfurt compared with $1.3206 before the press conference. Inflation expectations have more than doubled since August, with the gap between the yields on five-year German nominal bonds and similar-maturity index-linked debt climbing to 1.5 percent yesterday. Euro region consumer prices rose 2.2 percent in December.





“We see evidence of short-term upward pressure on overall inflation, mainly owing to energy prices, but this has not so far affected our assessment that price developments will remain in line” with the ECB’s definition of price stability, he said at a press conference in Frankfurt today. “Very close monitoring of price developments is warranted.”

‘Conditional Warning’

“It’s a conditional warning - ‘we will increase interest rates if inflation doesn’t moderate as we currently expect,’”

said James Nixon, co-chief euro-region economist at Societe Generale in London.

Trichet, whose term expires in October, may face his toughest year at the helm of the ECB. With divergences between euro economies increasing and market turmoil threatening to engulf Portugal, he must also decide when to stop buying government assets and withdraw unlimited liquidity provision for banks. Trichet said that the ECB’s monetary policy and its crisis- fighting measures are different and “disconnected’. Some ECB policy makers have warned that price stability, the bank’s primary goal, could be compromised if emergency measures are left in place too long. Withdrawing them too soon could frighten markets and push up the interest rates stricken nations have to pay on their debt, exacerbating the crisis.

Bond Purchases

The ECB said last month it will keep liquidity measures in place through the first quarter. Bond purchases, which so far total 74 billion euros ($98 billion), are “ongoing,” Trichet said. Lawmakers from German Chancellor Angela Merkel’s Bavarian allies, the Christian Social Union, told Trichet on Jan. 7 that the ECB should refocus on its core inflation fighting remit and limit its bond purchases. Economists forecast the bank will raise its key interest rate in the fourth quarter of this year, a Bloomberg survey shows. Trichet’s comments come as European governments consider aid for Portugal, debt buybacks, lower interest rates on rescue loans and guarantees against excessive debt as part of a package to quell the financial crisis, according to four people with direct knowledge of the talks. The plan would mark an attempt to contain a crisis that’s spread from Greece to Ireland and is threatening to infect Portugal and Spain. Trichet said the fund should be increased and given “maximum flexibility.”

Spanish borrowing costs increased in an auction of five- year bonds today. Spain will pay an average yield of 4.542 percent on the new securities, up from 3.576 percent at a similar auction in November.

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