Markets surprised by quarter-point rise

The European Central Bank (ECB) surprised the markets yesterday by increasing interest rates by a quarter of 1 per cent, bringing the main refinancing rate to 4.75 per cent. Yesterday's hike means that interest rates have risen by 2.25 per cent since November 1999 and, although analysts expected an increase before the end of the year, most were surprised by the timing of yesterday's decision.

Speaking to reporters after a meeting of the bank's governing council, ECB president Mr Wim Duisenberg said the increase in oil prices and the weakness of the euro against other currencies were the main factors behind the decision to raise rates.

"Contrary to earlier expectations, energy price developments did not moderate but rather continued to put considerable upward pressure on inflation rates. The low external value of the euro has heightened the risks of increases in import prices gradually being passed on to consumer prices," he said.

Mr Duisenberg insisted that the rate hike was not linked to last month's intervention in support of the euro by the ECB and other central banks, adding that the level of interest rates had not been discussed at any stage during negotiations with the US authorities prior to the intervention.

He declined to say if the ECB's governing council, on which the 11 central banks in the euro zone are represented, took a vote on the rate increase but said there was "the maximum possible consensus" in favour of the move.

Market analysts in Frankfurt broadly welcomed yesterday's decision as a necessary step to dampen inflation in the euro zone, which is running above the ECB's target level of 2 per cent. "I think that the development of economic growth is such that it could sustain an interest rate of 5 per cent," said Prof Norbert Walter, chief economist at Deutsche Bank.

Mr Duisenberg indicated, however, that yesterday's increase would be the last for some time and few analysts expect a further increase before the end of the year. "For me, the horizon is clear," Mr Duisenberg said, using a phrase he has employed in the past to suggest that there will be no further move on interest rates for some time.

A number of recent economic indicators suggest that the recovery in France and Germany, which together account for more than half of the euro-zone's GDP, may have peaked. Mr Duisenberg said yesterday that euro-zone growth may have reached a "cruising altitude" but predicted that growth would remain strong throughout 2001.

"While the possibility cannot be ruled out that the increase in oil prices as such may temporarily dampen growth dynamics over the short term, the forces underlying solid growth in the medium term remain in place. These relate to external demand, which is supported by a strong world economy, as well as to domestic demand, which is supported by both continued favourable financing conditions and strong employment growth," he said.

Mr Duisenberg claimed that the decision to increase interest rates would help to maintain strong growth by keeping inflation under control. But some analysts in Frankfurt were speculating yesterday that the ECB chose to increase rates now because it feared that economic growth would slow down later this year, making an interest rate hike more difficult to justify.

"I don't think it was an accident that the markets were not prepared in advance this time," said Mr Michael Holstein of DG Bank.