ECB to raise rates, play hardball on Greece

By Paul Carrel

FRANKFURT (Reuters) - The European Central Bank is almost certain to raise interest rates later on Thursday and will show no let-up in its insistence that governments solve Greece's debt crisis without triggering a default credit rating.

Financial markets see a quarter-point rise in the ECB's benchmark rate to 1.50 percent as a virtual certainty after the bank's recent reiterations that it is in a mode of "strong vigilance" -- code traditionally used to signal a hike.

Euro zone inflation remained at 2.7 percent in June, softer than expected but well above the ECB's target of just under 2 percent. The bank will not want to alarm markets by reversing its policy course because of Greece's troubles.

"It would be a very significant surprise if they don't hike tomorrow," said Nomura economist Jens Sondergaard.

"Basically, it would worry markets that, from the ECB point of view, the fundamental economic outlook has changed substantially over the last couple of weeks."

Markets will listen carefully for clues about the rate outlook for the remainder of the year, with analysts eager for the ECB's view on whether signs of a slowdown in the euro zone economy represent a 'soft patch' or a more marked deterioration.

Recent euro zone data has generally disappointed. The latest industrial orders rose less than expected, while growth in the bloc's dominant service sector has also slowed sharply.

Most analysts now see only one additional hike this year, as opposed to two that some had previously factored in.

If ECB President Jean-Claude Trichet says policy remains "accommodative" and the bank will monitor inflationary pressures "closely" or "very closely," expectations will be cemented for another hike this year -- likely in October or December.

"There is a small chance that the language could soften a bit, as the ECB tends to be more worried about inflation when growth is clearly above potential, which is not the case right now," JP Morgan economist Greg Fuzesi wrote in a research note.

"Even if this happens, we would expect the language to firm up again once growth re-accelerates later in the summer."


Beyond monetary policy, much of the ECB's news conference will focus on its stance on Greece and the euro zone periphery.

The downgrading of recently bailed-out Portugal's credit rating to junk rattled financial markets on Wednesday and cast new doubt on European efforts to rescue distressed euro zone states without debt restructuring.

The ECB is proving a major stumbling block in agreeing a second rescue plan for Greece as it has threatened to refuse to accept restructured Greek bonds as collateral in its lending operations in the event of a default or a "restricted default."

Refusing to accept Greek bonds as collateral would deprive Greek banks of the funds on which they rely, crippling the Greek economy and risking contagion to other euro zone economies.

By threatening to use this 'nuclear option', the ECB hopes to press the governments into avoiding a downgrade to default status, and the contagion it fears would follow.

"Is that a credible threat that the ECB is pushing at the moment? To us, it's probably not," said Sondergaard at Nomura. "But (Trichet) will stick with his line as long as he can and take it one month at a time."

JP Morgan's Fuzesi agreed: "We think the ECB would have to support Greek banks, despite its threats," he wrote.


While an increase in the main ECB rate looks certain, policymakers also have the less straightforward task of deciding what to do with the bank's marginal rates.

When the ECB cut its key refinancing rate, which it uses to lend funds in money market operations, to a record-low 1.00 percent in May 2009, it kept its overnight deposit rate at 0.25 percent.

That narrowed the corridor between the refi rate and the deposit rate, which commercial banks get when they park money at the ECB overnight and which acts as a floor for short-term market rates, to 75 basis points from the usual 100 bps.

Re-widening the corridor by leaving the deposit rate at 0.5 percent rather than lifting it in line with the main rate would soften the economic and political impact of the tightening.

After April's rate hike a number of ECB members said the corridor -- which also determines how much of a intermediation role the ECB plays in the money market -- should be reset sooner rather than later.

However, policymakers have not mentioned the subject in recent weeks and a Reuters poll on Monday showed a clear majority of money market traders expect the bank to leave things as they are for the time being.