All in a day's work: European Central Bank raises interest rates, speaks in favor of another rate increase, and says it will continue taking even junk-rated bonds from Greece and Portugal

07/07/2011 2:13 pm EST


Jim Jubak

Founder and Editor,

The European Central Bank raised its benchmark interest rate today, July 7, by 0.25 percentage points to 1.5%. The bank had repeatedly signaled a rate increase in the days heading into today’s central bank meeting in Frankfurt. Any other action today would have been a huge surprise.

And because the move was so widely expected, financial markets have reacted favorably but not strongly. The German DAX index was up 0.71% as of 11:30 New York time. The French CAC 40 index was up 0.73%. And the U.S. Standard & Poor’s 500 stock index was up 0.84%. The euro was up 0.21% against the U.S. dollar. Oil, which tends to move up when the dollar falls climbed with the price of Brent crude rising 3.4% and West Texas Intermediate up 2.5%.

But there were surprises—small and big—in the announcement.

The small surprise? In his press conference after the meeting outgoing European Central Bank president Jean-Claude Trichet sounded like a man who wants to raise interest rates again. Inflation is likely to stay above bank’s target of close to but below 2% in coming months. Monetary liquidity is ample and economic momentum remains positive. “All in all, it is essential that the recent price developments do not give rise to broad-based inflationary pressures over the medium term,” he said. I’d say the direction of the remarks wasn’t especially surprising but the strength of the comments was a bit more than I expected.

The big surprise? Trichet said that the European Central Bank will suspend its minimum credit-rating threshold on Portuguese bonds. That’s a definite thumb in the eye to Moody’s Investors Service which cut its rating on Portuguese government debt to junk yesterday. The bank will also suspend the threshold for Irish and Greek debt.

What that means is that the bank has decided to accept Portuguese, Irish, and Greek government debt as collateral for loans to national banks in those countries no matter what the credit rating on those bonds might be. Government officials in those countries should breathe a huge sigh of relief since the bank could have read its rules to say that it couldn’t take junk rated bonds as collateral.

This would seem to raise the chances that the bank will in addition, interpret its rules so that it could continue to accept Greek government bonds as collateral even if the credit rating companies decided that the second Greek rescue plan now under discussion had put the country into default. If the European Central Bank decides not to lend on Greek bonds as collateral, Greek banks will have found themselves cut off from their last source of liquidity and the Greek financial system would descend into chaos.

The European Central Bank has apparently decided that bending the rules is preferable to breaking the European financial system.

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