In Europe's Rate Debate, Shades of 2008

In Europe's Rate Debate, Shades of 2008

By BRIAN BLACKSTONE

The calendar may read April 2011 but, for Jean-Claude Trichet, July 2008 looms large.

As was the case nearly three years ago, the European Central Bank President is poised to oversee an interest-rate increase Thursday in the face of commodity-driven inflation. Other leading central banks are treading more cautiously, even with rates near zero, amid an uncertain economic outlook.

.The stakes are even bigger this time around. In 2008, the ECB was at the end of a tightening cycle. Now, any rate hike will likely be followed by more. And the crisis that could trip up Mr. Trichet is in his own backyard, the periphery of Greece, Ireland, Portugal and Spain.

The expected quarter-point rate rise won't put too much of a burden on the €9 trillion ($12.8 trillion) euro-zone economy as a whole. But the pain will be unevenly spread. For example, mortgages in the periphery are often tied to floating rates, so they rise with ECB rates. Those least affected? Germany, France and the Netherlands.

So what is the rush? Inflation is above the ECB's target, at 2.6%, but officials concede that second-round effects via higher wages and retail prices haven't materialized. Core inflation remains near 1%, roughly in line with the U.S. The recovery, though robust in Germany and its neighbors, still depends largely on exports.

For the ECB, it is about credibility. By raising interest rates now, officials show they are doing their job and trying to get ahead of inflation—demonstrating to businesses and unions they won't tolerate a wage-price spiral. It is also a signal to governments to step up crisis response, and to an increasingly skeptical German public that their euros are safe from inflation.


Jean-Claude Trichet, president of the European Central Bank
.Though criticized by most economists, Mr. Trichet still wears the 2008 rate increase as a badge of honor, proof of the ECB's commitment to price stability that has kept inflation at an average of 1.97% since the euro's inception. Quoted by Mr. Trichet at every possible occasion, that is in line with the ECB's target of just under 2%.

The risk for the savvy Frenchman is that he ends his tenure in October with the worst of both worlds: An even deeper rich-poor divide among his member countries and euro-era inflation still above the 2% level he has been so proud to defend.

Write to Brian Blackstone at brian.blackstone@dowjones.com