ECB signals interest rates rise as inflation fears bite

WARNING: The European Central Bank (ECB) has given a strong hint that interest rates will rise soon, warning that euro-zone inflation could reach 2.5 per cent this year. The warning came in six-monthly projections for the euro-zone economy, which were published yesterday alongside the ECB's monthly bulletin for June.

The report predicted that inflation would overshoot the ECB's 2 per cent target for the third successive year and warned that money supply growth was also a cause for concern.

It suggested that economic recovery was under way in the euro zone and would pick up speed later this year.

"All available forecasts of international organisations and the projections produced by Eurosystem staff point to a strengthening in both domestic and foreign demand, owing to favourable financing conditions, sound domestic fundamentals and the absence of major imbalances within the euro area, as well as a more favourable external environment," the report said.

Yesterday's report revised upwards the forecast for average euro-zone inflation in 2002 to a 2.1 to 2.5 per cent range from the 1.1 to 2.1 per cent range forecast six months ago.

The ECB economists also revised up their inflation forecast for 2003 to between 1.3 and 2.5 per cent from their December forecast of 0.9 to 2.1 per cent.

ECB president Mr Wim Duisenberg acknowledged last week that inflation would exceed the ECB's target this year.

Unusually, he declined to say that the present interest rate of 3.25 per cent was "appropriate". In answer to a reporter's question, Mr Duisenberg said it was no accident that he did not use the word.

Mr Tommaso Padoa-Schioppa, a member of the ECB's executive committee, gave a further hint that rates would rise when he told a Portuguese newspaper that the ECB remained vigilant to the threat of inflation.

"The deceleration of inflation to below 2 per cent is taking longer than we forecast a few months ago. Therefore, we are watching it," he said. The ECB's decision on when to raise interest rates could be influenced by the strength of the euro-zone's economic recovery and the performance of the euro against the dollar.

Stronger economic growth would encourage the ECB to raise rates but a strong euro would dampen inflation, perhaps to the point where a rate rise could be postponed until after the summer.

The euro this week reached a 17-month high against the dollar, climbing to $0.95. Asked if the European currency could continue to appreciate, Mr Padoa-Schioppa indicated that a further appreciation was possible. "I will limit my answer to the observation that when it was said that markets, in evaluating the euro, did not fully understand the strength of the European economy, the single currency was at that time above the current level," he said.

Market analysts expect interest rates to rise to 3.75 per cent within the next few months but they are divided over whether the increase will come in July or after the summer break. The ECB's governing council does not meet during the month of August.

•Bank of England governor Sir Eddie George warned yesterday the central bank would have to raise rates if consumer spending, driven by an "unsustainable" house-price boom, did not show signs of slowing. Financial markets saw Sir Eddie's comments as further evidence to support a general expectation that British interest rates will rise to 4.5 per cent by September from the current 38-year low of 4.0 per cent.