ECB raises rates, faces two-speed recovery

FRANKFURT, Germany (AP) -- The European Central Bank raised its key interest rate Thursday for the first time in nearly three years as it signaled its determination to fight inflation, even as some euro member countries still struggle with debt crises and high unemployment.

The quarter-point increase was widely expected and won't by itself hold back growth much. But Europe's increasingly two-speed recovery will be a challenge for the bank as it decides how high rates should go in coming months.

A day after Portugal finally accepted defeat in its battle to avoid a financial bailout, the ECB raised its refinancing rate to 1.25 percent from a record low of 1 percent, where it had been since May 2009. The refinancing rate determines the cost of central bank credit to commercial banks, and affects other short-term interest rates as well.

Europe's two-speed recovery presents the bank with a difficult challenge in the months ahead, as it seeks to return interest rates to more normal levels from the emergency lows that supported the economy in the wake of the global financial crisis. Higher rates help control inflation but can weigh on growth.

On the one side, Portugal is set to join Greece and Ireland in taking a rescue package and Spain is struggling with a 20 percent unemployment rate. On the other, countries like Germany are enjoying robust growth, booming exports and falling unemployment; leading economic institutes are predicting that the jobless rate will average only 6.5 percent next year, and that's including the former East Germany's lagging economy.

Some parts of southern Germany have unemployment rates at 4 percent or lower, and skill-intensive jobs are going begging. Those numbers indicate that some parts of Europe's biggest economy maybe on the verge of overheating and that's a recipe for higher prices.

Because the European Central Bank's mission is to control inflation, it is raising rates, even though that will put more pressure on hard-hit consumers with mortgages and the collapsed real estate markets in the so-called peripheral countries.

It was clear from bank President Jean-Claude Trichet's comments following the rate decision that the anti-inflation message was most important now, and that it was up to countries on the slow track to go through the painful process of reducing debt.

Trichet said keeping inflation in check would benefit all members. The key for countries in trouble was to stick to the requirements of their bailout agreements with the European Union and the International Monetary Fund.

"We have a number of countries which have to correct their situation, particularly on the fiscal side, not only the fiscal side, but economic policy in general," he said. "Plans are in place and they have to apply the plan."

ING economist Carsten Brzeski said higher rates risked increasing the growth divide as consumers paid more to borrow.

"Higher ECB rates will neither choke off the recovery in the periphery nor will they weigh on public finances but they will not make life of the eurozone periphery easier," he said. "The start of the normalization cycle will increase, not diminish, divergence within the eurozone."

The ECB is worried that inflation, which hit 2.6 percent in March, will remain stuck above its target of "close to, but just under 2 percent." Critics of a rate hike have noted that inflation has been mainly driven by higher oil and food prices, largely external factors the ECB cannot control through its policies.

Trichet said the bank was determined to move pre-emptively to keep higher prices from causing a spiral effect in which higher inflation expectations cause wages to go up, in turn boosting consumer prices further.

The ECB is charting a different course from the U.S. Federal Reserve, which has not yet signaled readiness to begin raising rates from the current rock-bottom 0-0.25 percent.

The Bank of England's monetary policy committee left rates untouched at 0.5 percent at its meeting Thursday even though inflation in Britain is running at 4.4 percent.

Trichet did not commit to a series of increases, but left the door open for what analysts think will be several more by the end of the year. "We did not decide that it was the first of a series of rate increase," he said, adding that each month "we always do what is necessary to deliver price stability."

He did not, however, express the need for "strong vigilance" against inflation -- a term regarded as a signal to markets that rates are going up the next month.

Instead, he said the bank would "monitor very closely" the risks of rising prices, which he said "remain on the upside" -- phrasing that seemed to leave the bank room to pause for a month or two before acting again.

Economist Marchel Alexandrovich at Jeffries International Limited said that the ECB's policy was clearly aimed at the overall economy for now: "With the periphery of Spain, Greece, Portugal and Ireland combining for less than 20 percent of euro area GDP, clearly the ECB's focus is predominantly elsewhere."

He cautioned however that as rates go higher, the impact would be felt more strongly by consumers paying down mortgages in Portugal, Ireland, Spain and Italy than in Germany, France, Belgium and the Netherlands, where fixed-rate mortgages are the norm.

Business borrowing costs would also hit Spain, Portugal and Ireland harder than Germany and France because of higher levels of corporate debt.

"One more reason why the ECB would be wise to tread very carefully in the months ahead," Alexandrovich said.