ECB raises rates in spite of peripheral troubles

For the first time since July 2008, the European Central Bank raised interest rates across the eurozone by 25 basis points to 1.25%, despite escalating costs for the region’s periphery.

Portugal is likely to be hit by the move, after it announced yesterday it needs a bailout on similar scale to that allocated for Ireland in November last year.

Portugal will go to the ECB for a sum of €70bn to €90bn, but may ask for an interim bridge loan before requesting a full rescue in June.

In anticipation of the bailout request, Moody’s downgraded the senior debt and deposit ratings of seven Portuguese banks and downgraded five of the banks’ standalone credit assessments yesterday, Wednesday 6 April.

The latest move by the ECB’s governing council will put pressure on the rest of the eurozone’s periphery too, when it comes into effect on 13 April 2011.

More than ever, the non-core part of the region will be dependent on export growth as higher rates will squeeze household spending in the PIGS harder than in Germany and France.

Peripheral European borrowers favour flexible rate mortgages whereas core European borrowers opt for long-term fixed rate deals. That means increases in official rates are more likely to feed through rapidly to monthly repayment rates in peripheral Europe.

Average mortgage rates in peripheral countries are between 2.2% (in Portugal) and 3.7% (in Greece). They are far higher in core Europe.

Darren Williams, Alliance Bernstein’s senior European economist for global economic research said “households in the periphery are likely to be hit disproportionately.”

But Williams added this was not a valid reason for the ECB to postpone rate hikes.

“Monetary policy is set on the basis of aggregate economic conditions in the whole of the euro area. And data for the euro area as a whole suggest that the time for emergency low interest rates, set to counter the risk of deflation, is drawing to a close.”

He said the quicker-than-expected recovery in eurozone growth was benefiting export growth in the periphery, and this could outweigh any negative impact on the household purse.

An increase by the ECB was expected, after President Jean-Claude Trichet signalled last month it was likely but that it was not the first of several in a row.

Trichet is speaking this afternoon at 2.30pm CET on what triggered the decision. It follows a decision earlier by the Bank of England’s Monetary Policy Committee (MPC) to hold its rates at 0.5%, an historic low lasting for 26 months so far.

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