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ECB’s primary mandate is 2% inflation, then support the general economic policies

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Jean-Claude Trichet is bypassing the European Central Bank’s little-known secondary mandate as inflation propels policy makers toward the first interest-rate increase in three years.

While the ECB president signaled on March 3 that he may have no choice other than to tighten monetary policy, the bank’s statutes hand officials leeway to pursue policies supporting economic growth. The Maastricht Treaty says the central bank can keep rates low if policy makers judge that price stability is guaranteed. The ECB itself forecasts inflation will slow below its 2 percent ceiling next year.

“The markets didn’t expect such a shift to the primary mandate so soon,” said Jens Sondergaard, senior European economist at Nomura International Plc in London. “The ECB’s balancing act is especially tricky, with inflation risks crystallizing and the flare-up in the sovereign debt crisis.”

With inflation currently at 2.4 percent, unemployment at 9.9 percent and yields on Irish, Greek and Portuguese bonds close to records, Trichet last week had a choice: Keep his inflation fight limited to rhetoric or declare it was time to raise rates.

Trichet opted to say that the ECB will probably raise its benchmark from 1 percent in April, saying “strong vigilance” is needed. Bundesbank President Axel Weber on March 8 said the move may be the first in a series of increases.

ECB Flexibility

“Everybody underappreciated how significant the rise in inflation expectations was for the ECB,” said Julian Callow, chief European economist at Barclays Capital in London. “It’s surprising all around that they did move in this way.”

The ECB’s primary inflation mandate, which it interprets as keeping inflation just below 2 percent in the medium term, is enshrined in 1991’s Maastricht accord. Once this is achieved, the rulebook also allows it to “support the general economic policies” aimed at delivering high growth, social protection and economic convergence.

That’s a contrast to the U.S. Federal Reserve, whose officials are mandated to balance low inflation with high employment. The ECB’s preferences for monitoring inflation are a throwback to the era when the Bundesbank set monetary policy for Germany, the euro-area’s largest economy.

“The market tends to underestimate the determination of the ECB on inflation, period,” said Holger Schmieding, chief economist at Joh Berenberg Gossler &Co. in London. “By history and mandate it is much more focused on inflation” than other central banks such as the Fed, he said.

Inflation Mandate

Trichet told reporters last week that price stability is the bank’s “primary” mandate. That follows 10 months buying government bonds to shore up the region’s most indebted countries and repeatedly delaying the withdrawal of unlimited liquidity for banks.

As of a week ago, just four of 38 economists surveyed by Bloomberg News anticipated the ECB would raise its benchmark in the first half of this year. The majority mistook the ECB’s priorities, said Natascha Gewaltig, director of European economics at Action Economics in London and one of the four in the minority.

“People get into a mindset that’s difficult to get out of, but if you’ve actually been listening to the ECB it’s been getting clearer that they were nearing a rate hike,” said Gewaltig. “Overall euro-zone inflation and growth rates just don’t justify a 1 percent rate.”

ECB Concern

The ECB’s concern is that above-target inflation will generate a push from workers and companies for higher wages and prices, leading to faster so-called core inflation which tends to be more long-lasting than that driven by fuel or food price shocks. While the ECB’s forecasts show that officials expect inflation of just 1.7 percent in 2012, that’s still up from a previous estimate of around 1.5 percent.

Germany’s economy is also keeping up momentum after growing last year at the fastest pace in two decades. Unemployment plunged in February by three times as much as economists forecast and retail sales rose for a second month in January, data showed last week. The country accounts for about a third of the euro area’s gross domestic product.

Another reason for tighter credit is to “increase pressure” on governments to tackle the debt crisis amid concern that their failure to cut budget deficits and toughen fiscal policy rules threaten to fan inflation pressures, said Juergen Michels, an economist at Citigroup Inc. in London.

Trichet Boast

While Trichet often boasts that inflation has averaged about 1.9 percent since the euro began trading, the ECB has sometimes been willing to turn a blind eye to short-term breaches of its price target to help growth. Officials waited 10 months before responding to an overshoot of their goal with a rate increase in December 2005.

The ECB’s latest shift is not without risks. Geoffrey Yu, a foreign exchange strategist at UBS AG, says investors are drawing parallels with July 2008, when officials raised the key rate to a record high of 4.25 percent to tame the fastest inflation in 16 years. Subsequent data showed the economy was shrinking at the time and the ECB reversed the move three months later following the collapse of Lehman Brothers Holdings Inc.

“Tightening was too early and widely perceived as policy error,” said Yu of 2008. Trichet disagrees, arguing that by acting it enforced the ECB’s inflation-fighting credibility and gave it more room to fight the credit crisis.

Risk of Error

The risk of policy error may make the ECB cautious about how far it goes beyond April. Trichet says any increase may not be the start of a series. Economists at JPMorgan Chase & Co., Nomura and Morgan Stanley all predict the ECB will end the year with its benchmark at 1.75 percent.

Trichet could also take a last-minute decision not to follow the demands of the primary mandate if EU leaders this month fail to staunch renewed concerns about the euro region’s debt crisis. Heads of government meet in Brussels today for the first of two summits this month aimed at ending the crisis and creating a new rulebook for the region.

“In practice, the ECB will only really be in a position to consider raising rates in April or May if conditions to some degree normalize after the March 24-25 meeting,” said David Owen, chief European economist at Jefferies International Ltd. “By their actions, the ECB has certainly put more pressure on the politicians to come up with a big bang solution.”

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