ECB ready to raise rates as economy shows strength

The European Central Bank (ECB) is ready to push ahead with interest rates increases this week and beyond, after proving wrong the doomsayers who had predicted its four hikes so far would upend the euro zone's recovery.

ECB policymakers have reason to feel smug. The economy's surprising strength is forcing financial markets to reconsider how far the rate rises might go, and not even a welcome drop in oil prices and inflation is likely to break their stride.

A fifth hike of a quarter percentage point to 3.25 per cent is a virtual certainty when the ECB's governing council meets in Paris on Thursday, and one more hike in December looks probable.

From the International Monetary Fund to the OECD, most advice until recently had been to hold off on tightening.

But the ECB pressed ahead, and now the 12-nation region is strutting its best economic outturn since the boom days of 1998-2000, while inflation is retreating.

Corporate profits are high, private spending is starting to revive and the jobless rate has tumbled to its lowest level in five years.

"For central bankers, it says that the economy is strong enough to absorb further steps toward monetary policy normalisation," said Eric Chaney, European economist for Morgan Stanley. After the year-end, the outlook is less clear. If strong growth continues - as ECB staff currently predict - rates of at least 4 per cent by the end of 2007 should not be ruled out, one senior ECB central banker told Reuters recently.

Policymakers are looking beyond short-term consumer price data. Inflation retreated in September to 1.8 per cent, the lowest since March 2003, after a 17 per cent drop in oil prices in two months.

That put the rate below the ECB's 2 per cent ceiling for the first time since January 2005, and inflation expectations in the European Union sentiment survey and index-linked bonds are starting to retreat.

But executive board member Jose Manuel Gonzalez-Paramo said last week that the ECB's focus is on the medium term, not one-off changes.

"Monetary policy cannot offset short-term changes in inflation caused, by example, oil," he said.

ECB policymakers also stress that borrowing costs remain extremely cheap.