The European Central Bank's chief shocked markets Thursday by saying interest rates could be raised at the next policy meeting in April to fight inflation across the 17-nation eurozone.
Speaking after the bank left its main interest rate unchanged at the record low of 1 percent, President Jean-Claude Trichet said "strong vigilance" was warranted and that an interest rate increase next month was "possible" though "not certain."
"It is paramount that the rise in inflation does not lead to second-round effects and thereby give rise to broad-based inflationary pressures over the medium term," said Trichet.
In economic terms, second-round effects are wage increases, which threaten to embed high inflation in an economy.
The scale of Trichet's hawkishness came as a big surprise in the markets. The euro shot up around a cent to around $1.3950 while bond prices across the single currency zone fell.
"Markets were expecting big things from the ECB's press conference, and Trichet delivered," said Benjamin Reitzes, an analyst at BMO Capital Markets. "The bank appears eager to prove its inflation-fighting credentials."
However, Trichet appeared to dismiss the notion of a big rate increase — that is, more than a quarter point — arguing that it was "not appropriate." He also sought to downplay any suggestions that an April interest rate rise would necessarily lead to more rises over the months ahead.
"It is certainly not the sense of the start of a series of rate hike increases," he said.
Trichet said risks to prices are "on the upside" and the whole governing council is "prepared to act in a firm and timely manner" to keep inflationary pressures from mounting.
"The continued firm anchoring of inflation expectations is of the essence," Trichet said.
Although an interest rate increase can put downward pressure on inflation, many countries in the eurozone will fear the knock-on impact on their economies — higher interest rates make borrowing more expensive and generally act as a restraint on growth.
Two countries that come to mind are Portugal and Greece, both of which are expected to contract further in the months ahead.
Marie Diron, a senior economic adviser to accounting firm Ernst & Young, said a premature ECB rate rise as a response to an energy-fueled price spike would be a "policy mistake."
The ECB's only mandate is to control inflation — unlike the U.S. Federal Reserve, which also has to keep a close watch on the wider U.S. economy, in particular the U.S. labor market.
Given that backdrop, the current spike in inflation is proving increasingly uncomfortable for Europe's central bank.
In the year to February, higher food and energy costs pushed consumer price inflation in the eurozone up to 2.4 percent — further above the ECB's keenly held mandate of keeping price increases "close to but below" 2 percent.
The ECB also published its staff forecasts, and these confirmed that inflationary pressures have swelled since the last time they were published in December.
Trichet cautioned that the forecasts were made before the latest spike in crude prices due to the tensions in Libya.
"It should be stressed that the projections are based on commodity price futures as of mid-February 2011, and therefore do not take into account the most recent oil price increases," Trichet said. "Moreover, it needs to be emphasized that the projections assume continued moderate domestic wage and price-setting behavior."
The prediction is now that inflation in the eurozone will be between 2.0 percent and 2.6 percent in 2011 and between 1.0 percent and 2.4 percent in 2012.
Though Trichet was sounding tough on inflation, he said the ECB would continue with its crisis measures to give banks as much liquidity as they require to deal with ongoing liquidity problems.
"The provision of liquidity and the allotment modes will be adjusted as appropriate, taking into account the fact that all the non-standard measures taken during the period of acute financial market tensions are, by construction, temporary in nature," Trichet said.
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