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ECB to Hike Rates, Remain Unflinching on Greece

Monday, 04 July 2011 02:29 PM

The European Central Bank is set to hike euro zone interest rates to 1.5 percent on Thursday and is expected to show no sign of softening its hard-line stance that Greece must not be allowed to default on its debts.

The ECB's second rate hike of the year is seen as a virtual certainty by financial markets after the bank's recent reiterations that it is in a mode of "strong vigilance" -- a phrase traditionally used to signal a rate rise.

Euro zone inflation remained at 2.7 percent in June, softer than expected but well above the ECB's preferred level of just under 2 percent. The bank will also not want to risk pulling its plans and sending the message that Greece's troubles are making it jittery about the wider recovery.

"We think that the situation is "not bad enough" for the ECB to reconsider its nearly pre announced rate hike, especially now that Greece -- and the peripherals -- have won a respite (with extra aid)," said Deutsche Bank economist Gilles Moec.

Markets will be listening for any hints on further policy tightening.

Economists have been toning down rate hike expectations in recent weeks as it has become clear the euro zone recovery is slowing at the same time as the debt crisis is intensifying.

The focus will be on whether Trichet puts more emphasis on the level of uncertainty hanging over the economy and whether he still defines the ECB's interest rates as "accommodative," a phrase that would signal the bank remains in a tightening mode.

Recent euro zone data have generally disappointed . The latest industrial orders rose less than expected, while growth in the bloc's dominant service sector has also slowed sharply.

Most analysts now see only one additional hike this year, as opposed to two that some had previously factored in.

"We think that the ECB will take a long pause after July ... We do not expect a further hike to come before December," said Moec, adding that further hikes at a time when the U.S. Federal Reserve was still on hold would also put pressure on the euro.


Greece's strife is set to dominate questions during the post-meeting news conference with the ECB's President Jean-Claude Trichet on Thursday.

The ECB has been particularly vocal in the debate over a new Greek bailout deal, threatening to stop accepting the country's debt as collateral if bondholders are strong-armed into a deal that rating agencies would view as a Greek default.

S&P, one of the three big rating firms, on Monday damaged hopes that a French-led plan where banks reinvest half of the proceeds of maturing Greek debt in new 30-year bonds could be the answer.

If no palatable solution is found and the ECB refuses Greek debt, it could trigger a new wave of banking turmoil. Yet a climbdown would be an embarrassing blow to its reputation.

Sarah Hewin, an economist at Standard Chartered, thinks the ECB will pursue its hard line this week against Greece and other euro zone debtors, but eventually cave in.

"Trichet will stick to the line that there should be no default, that is the only thing they can say," she said.

"Unless the EU is willing to fund Greece completely over the medium term -- and that looks unlikely considering the opposition from some of the northern countries -- the ECB will have to decide whether it really will stop accepting Greek debt as collateral as the consequences could be very damaging."



While an increase in the main ECB rate looks certain, policymakers also have the less straightforward task of deciding what to do with the bank's "marginal" rates.

When the ECB cut its key refinancing rate, which it uses to lend funds in money market operations, to a record-low 1.00 percent in May 2009, it kept its overnight deposit rate at 0.25 percent.

That narrowed the corridor between the refi rate and the deposit rate, which commercial banks get when they park money at the ECB overnight and which acts as a floor for short-term market rates, to 75 basis points from the traditional 100 bps.

Re-widening the corridor by leaving the deposit rate at 0.5, percent rather than lifting it in line with the main rate, would soften the economic and political impact of the tightening.

After April's rate hike a number of ECB members said the corridor -- which also determines how much of a intermediation role the ECB plays in the money market -- should be reset sooner rather than later.

However, policymakers have not mentioned the subject in recent weeks and a Reuters poll on Monday showed a clear majority of money market traders expect the bank to leave things as they are for the time being.

"I do not think they could care less about the band," said one money market dealer.

"The order of priority they have is to get Greece settled, hope there are no other periphery problems, get out of the full allotment (limit-free lending) and then get out of the narrow band," he added.

© 2021 Thomson/Reuters. All rights reserved.

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The European Central Bank is set to hike euro zone interest rates to 1.5 percent on Thursday and is expected to show no sign of softening its hard-line stance that Greece must not be allowed to default on its debts. The ECB's second rate hike of the year is seen as a...
Monday, 04 July 2011 02:29 PM
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