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updated: 8/2/2011 7:19 AM

Economic fears could deter ECB rate hikes

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  • President of European Central Bank Jean-Claude Trichet

    President of European Central Bank Jean-Claude Trichet
    Associated Press

Associated Press

FRANKFURT, Germany -- Worries about Europe's economy and a possible worsening of the debt crisis could force the European Central Bank to abandon a third interest rate increase that had been widely predicted for later this year.

No change is forecast in the bank's key rate of 1.5 percent at Thursday's meeting of its governing council, but remarks by President Jean-Claude Trichet will be scrutinized for any darkening of the bank's risk assessment.

Until recently, many analysts expected the bank would lift rates by a quarter-point in October to keep inflation from taking hold, following increases in April and July.

Some analyst now say that more hikes may have to wait, in the face of a string of downbeat economic signals.

CEOs of big German companies such as Siemens, Volkswagen and BASF gave cautious earnings predictions last week, while key economic indicators, such as Monday's manufacturing sector surveys, are sagging both in Europe and in key trading partners like the U.S.

Markets have also been shaken by the debt crises both in Europe and the U.S.

Investors are demanding elevated interest rates on Italian and Spanish government bonds, suggesting a second bailout for Greece, agreed July 21 by eurozone leaders working with Trichet, has not eliminated the debt crisis and the risk that it could spread beyond bailout recipients Greece, Ireland and Portugal.

The U.S., meanwhile, narrowly avoided defaulting on its debt when Congress struck a deal Sunday on raising the federal debt ceiling. The uncertainty, however, has rattled markets as a downgrade seems unavoidable and growth is expected to slow.

The combination of troubling economic indicators could lead the bank to pause further rate hikes, since interest rate increases can weigh on growth if they hit an economy that is not expanding strongly. Higher rates are central banks' chief way of controlling inflation.

"The window of opportunity for further rate hikes seems to be closing faster than expected," said Carsten Brzeski, senior economist at ING in Brussels. "The latest batch of confidence indicators has again fueled doubts about the strength of the eurozone economy."

The manufacturing surveys showed a slowdown in activity Germany and the Netherlands, two countries that have enjoyed good growth even during the debt crisis, while Italy, the No. 3 eurozone economy, was stagnant.

Those numbers followed cautious or downbeat outlooks on the future last week from top European companies, including big German industrial firms that have been riding a boom in exports in recent quarters.

Some economists who follow the ECB think it will still carry through with at least one more increase this year.

Marc Ostwald at Monument Securities expects the bank to say it is exercising "strong vigilance" against inflation at the September meeting. That code phrase has been used to signal a rate increase will likely be delivered in October.

After all, inflation at 2.5 percent remains well above the official target of close to but below 2 percent. However, the latest figures was down slightly from the previous month, suggesting slowing growth may be dampening price pressures.

Besides weakening growth, Europe's government debt crisis still hangs over the ECB. July's euro109 billion bailout agreement secured Greek financing into 2014, but did not reduce investor fears about potential troubles in Italy and Spain -- the Italian 10-year bond traded above 6 percent on Tuesday, where it was during the anxious days ahead of the bailout summit. Those two countries would be too large for the eurozone's euro440 billion rescue fund to save if bond markets balked at lending them more money.

Trichet has said that the bank chooses the best interest rate for the eurozone as a whole to deliver on its mandate of keeping inflation down, and won't let the debt troubles keep it from fighting inflation.

Still, analysts at Royal Bank of Scotland say that if yields Spanish 10-year bonds rise above 6.5 percent and stay there, the bank will have little choice but to substantially delay more rate hikes. On Tuesday the yield was 6.37 percent.