Here Comes a Rate Hike from the ECB…

While it wasn’t a surprise that the European Central Bank (ECB) decided to keep its interest rates on hold at 1.00% last week, I bet many weren’t expecting ECB President Jean-Claude Trichet to be uber hawkish on the markets!

Within minutes after the statement, the euro staged a magnificent rally against the dollar, and flew more than 100 pips! By the end of the week, thanks to increased interest rate hike speculations, EUR/USD managed to surge to 1.4007 to mark a new yearly high.

According the to the accompanying statement, ECB President Jean-Claude Trichet and his merry men believe that inflation could reach 2.2% by the end of the year, a bit above their 2.0% target. To fight accelerating inflation, Trichet said that “strong vigilance is warranted” and suggested that a rate hike in the next meeting is highly possible.

Increasing inflationary pressures usually signal a healthy economy, right? If that’s the case, then why do the ECB members’ speeches suggest that they are losing sleep (and hair) worrying about it?

If you’ve been reading the best forex education site, then you’ll know that rising inflationary pressures usually mean that strong economic demand is pushing prices higher. In the euro zone‘s case, however, rising prices is caused not by local demand, but by external pressures.

For the past several weeks, political riffraff in the Middle East have been threatening the supply of commodities. In fact, they have even pushed oil prices above the $100 per barrel mark in the last few days!

The ECB worries that if left unchecked, rising commodity prices could produce “second round effects” in the economy, a situation where companies would hike their prices and workers would demand higher pay to compensate for higher prices. This would produce a vicious cycle that could accelerate inflation. Phew! Good thing the ECB members are sounding more hawkish then!

Now I know some of you are already preparing to lock and load pips on the euro, but you may want to take it easy. A rate hike ain’t a done deal yet!

Central bankers usually have a way with words just like Big Pippin has when it comes to the ladies. If the ECB’s sweet words could boost the euro enough to weigh down inflation, then why should the ECB still resort to raising rates? Doing so could only make it harder for debt-ridden euro zone members to pay back their debts. Not to mention that a rate hike could also dampen economic growth.

Speaking of economic growth, the ECB can also rely on the strong euro to help tame inflation. A strong currency weighs on exports, and may consequently make manufacturers less confident in passing on additional expenses to consumers.

All things considered, a rate hike in the next two months isn’t a sure thing. Even if it seems like ECB President Jean-Claude Trichet has somehow lost his cool in the midst of skyrocketing commodity prices, I’m pretty sure he remembers what happened the last time the ECB raised interest rates in reaction to an oil spike.

Three months after hiking the official cash rate by 25 basis points to 4.25% in July 3, 2008, the central bank announced a series of rate cuts to stimulate growth. It started with a 50 basis point deduction in October to 3.75% that eventually landed rates at 1.00% in May 2009.

A premature rate hike could send the euro zone into the rut that every economy dreads and is characterized by high inflation and weak growth–stagflation. Duhn, duhn, duhnnn!