FRANKFURT, Germany – For the European Central Bank, dedicated to slaying the dragon of inflation, the moment of truth arrived yesterday. The bank raised its benchmark interest rate one-quarter of a percentage point to 4.25 percent, making good on a promise last month that it would act to curb food and fuel prices.
But with Europe's economy slowing, the bank stopped well short of signaling the beginning of a new round of rate increases, as a lot of bank watchers had expected. “Starting from here, I have no bias,” the bank's president, Jean-Claude Trichet, declared at a news conference.
Trichet's measured words soothed markets, helped halt a slide in the dollar against the euro, and may have mollified European leaders worrying that higher exchange rates could choke their weakening economies.
The bank's decision to tighten credit has been watched, and debated, as much as any in its 10-year history because it comes just as economic growth appears to be deteriorating in Europe. It also widens the gulf in monetary policy between Europe and the United States, where the number of jobs declined for the sixth straight month in June.
The Federal Reserve, with interest rates half those in Europe, has not raised them so far, though it has indicated that inflation is a growing concern. Other central banks, from Scandinavia to Southeast Asia, lifted rates this week to combat a global wave of inflation.
“The ECB is the only major central bank that is joining the smaller central banks in raising rates,” said Thomas Mayer, the chief European economist at Deutsche Bank in London. “The others are talking tough, but the ECB is the only one that is putting action to words.”
This has put the bank in an awkward position. Politicians in France and Germany urged it not to raise rates at such a fragile moment. Even within the bank's 21-member governing council, there was a raging debate about whether to act now or hold off, to avoid jeopardizing growth.
The latest statistics, which showed inflation in Europe spiking to 4 percent in June – twice the upper limit set by the bank – seem to have settled the debate for the moment, economists said. Trichet said the vote to raise rates one-quarter point was unanimous.
Underlining the argument that the move was more of a one-time gesture than the beginning of a trend, Trichet repeated a warning to unions not to use inflation as a pretext to demand steep wage increases. The bank frets as much about “second-round effects” as it does about inflation itself, economists said.
“They've really gotten everyone's attention,” said Holger Schmieding, chief European economist at Bank of America. “Trade unions, governments and others know the bank is dead serious.”
Politicians were muted about the rate increase, after days of noisy public pressure on the bank from French President Nicolas Sarkozy, German Finance Minister Peer Steinbrueck and other leaders.
But unions reacted sourly, disputing that inflation could start a wage-price spiral. “The ECB should realize we are no longer living in the '70s,” the European Trade Union Federation said in a statement.
While Trichet reiterated that the central bank's overriding mandate is to manage expectations about inflation, he also acknowledged that the economic picture in Europe is worsening.
Manufacturing activity in the 15 countries that use the euro shrank in June for the first time in three years, according to a survey of European purchasing managers. In Spain and Ireland, where a collapse in housing prices has magnified the problems, there is significant risk of a recession.
Europe's growth this year will be “not at all flattering,” Trichet conceded, though he disputed suggestions that it faces stagflation similar to what occurred after the oil shock of the 1970s.
With Europe likely to slow further in coming months, however, economists said the inflation hawks on the bank's governing council – led by Axel Weber, president of Germany's Bundesbank – would find it difficult to round up votes for more than one additional rate increase this year.
“We still think there is a need to hike further,” said Elga Bartsch, senior European economist at Morgan Stanley in London. “But given what I heard today, there won't be any rush to do it.”
