ECB raises interest rates to five-year high of 3.75%

The European Central Bank raised its key interest rate by 25 basis points to 3.75 per cent today.

The European Central Bank raised its key interest rate by 25 basis points to 3.75 per cent today.

The widely expected decision took euro zone borrowing costs to their highest since November, 2001.

Signs that euro zone economic growth remains solid plus hints from ECB President Jean-Claude Trichet last month when he said inflationary risks require "strong vigilance" prompted economists to predict a March rise.

The ECB has raised rates seven times from 2 per cent since the start of the current cycle in December 2005.

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Inflation, currently at 1.8 per cent, has been in line with the ECB's price stability target since September, prompting some trade unions to question why further rate increases are needed.

But the ECB is concerned about risks from oil prices, rapid money supply growth and broader wage and price pressures as the economy grows at or above its fastest sustainable pace.

In addition to raising the minimum bid rate for its main refinancing operations, the ECB also said it was raising the rates on its marginal lending and deposit facilities by 25 basis points to 4.75 per cent and 2.75 per cent, respectively. These changes are effective from March 14th.

An ECB warning of "vigilance" has preceded every rate increase since it began raising rates in December 2005.

Mr Trichet said this afternoon that although rates now are moderate, monetary conditions still support economic growth in the region and the Governing Council is ready to squelch inflationary pressures.

"Our monetary policy continues to be on the accommodative side, with the key ECB interest rates moderate, money and credit growth vigorous, and liquidity in the euro area ample by all plausible measures," he said.

European government debt slipped on these comments, with Euribor futures pricing in a greater chance that ECB rates would continue climbing this year. But the euro currency lost some ground, seeing rates nearing a peak.

Mr Trichet's description of interest rates as moderate marked a slight change in tune. Until now he has called euro zone interest rates "low", so the new language recognises that after 175 basis points of increases since December 2005, credit conditions are less stimulative.

However, Mr Trichet allowed the bank some room over how monetary policy will unfold in the months ahead. He avoided saying that the ECB plans to step hard on the monetary brake to slow down growth and strangle inflationary pressures.

"If I was preparing the market for us being restrictive, I would have said that. I did not say that," he said. At the same time, he left the door open to further rate increases. "I did not say we were at a peak, full stop."

Market analysts said this language, combined with new projections for strong growth and inflation to climb again next year, suggest that ECB rates are heading to 4.0 per cent and possibly higher.

ECB staff revised the inflation outlook for 2008 upward to a 2 per cent midpoint from 1.9 per cent forecast three months ago. This means the ECB sees a reasonable chance it would fail to meet its price stability goal of inflation just below 2 per cent next year, unless it tightens monetary conditions further.