ECB talks rate hikes, braces as Portugal crisis deepens

European Central Bank policymakers underscored the case for an April rate hike on Thursday as Portugal's political crisis raised the prospect of another spell of reluctant ECB bond market intervention.

The ECB has kept rates at a record low of 1 percent for almost two years as the financial and debt crises have unfolded, but it took financial markets by surprise earlier this month by flagging a earlier-than-expected hike in April.

This month's disaster in Japan, Middle East tensions, and most recently signs Portugal's government will fall, potentially forcing the country into a European bailout, have created some uncertainty in markets about an ECB hike.

But policymakers appear committed to a rise.

Observers appear to have correctly understood the ECB's intention when, in its public communication, it dropped its references to interest rates being 'appropriate', heavyweight ECB Executive Board member Juergen Stark wrote in a guest column in the Wall Street Journal.

Stark, who heads the ECB's economics division, said the bank needed to be wary of keeping interest rates too low for too long and warned of over-sensitive monetary policy responses to events like the Japan catastrophe.

Financial markets cannot expect monetary policy to be eased as a knee-jerk reaction to all emergencies, he wrote.

The ECB has been driven toward interest rate hikes by a much faster-than-expected rise in euro zone inflation since the height of the financial crisis, he added.

Inflation in the 17-country bloc hit a 28-month high of 2.4 percent in February and oil prices at a 2-1/2 year high are boosting expectations that it could remain above the ECB's preferred target of just under 2 percent for an extended period.

Stark also noted that real euro zone interest rates were currently even lower than those in the U.S. in the 1970's when low rates fueled a particularly damaging spell of inflation.

Estonia's ECB Governing Council member, Andres Lipstok, in his first published comments since his country joined the euro on January 1, added his voice to the inflation worries.

Global price rise pressures have been annoyingly enduring and do not show any signs of abatement, Lipstok told the Postimees daily. The current euro area interest rate level is not suitable for guaranteeing the low inflation rate that corresponds to the price stability goal.

Erkki Liikanen, from neighboring Finland, struck a similar tone at a news conference to present the Finnish central bank's quarterly report, saying market expectations for interest rate rises have returned to a 'normal' level after a drop in the wake of the Japan earthquake.

PORTUGAL TEETERS

The resignation of Portugal's prime minister Jose Socrates on Wednesday has added an extra layer of uncertainty for the ECB, other European policymakers and markets.

It has left Portugal in uncertain political terrain after months of battling against growing concerns over its ability to tame its public finances and avoid following Greece and Ireland to seek international aid.

The topic of whether a bailout is now inevitable will dominate a summit of EU leaders on Thursday and Friday. ECB observers are speculating whether the bank will reluctantly engage itself in another round of government bond purchases.

The wild card here is the European Central Bank. If they don't get involved then you want to be short Portuguese bonds, but if they do start buying bonds in the current thin market then you're going to get hurt very quickly if you're short, said Nomura rate strategist Sean Maloney.

Finland's Liikanen said the ECB would see how the situation panned out. We have to wait and see how Portugal reacts with this crisis, he told reporters.

The ECB bought no bonds for the last three weeks despite steadily increasing spreads, playing a similar hand to the one it did running up to Ireland's bailout deal.

DZ Bank economist Thomas Meissner said the ECB was likely to stay out of markets for the time being to ratchet up pressure on Portuguese and euro zone politicians.

Portugal is not on the brink of collapse. The debt is not that much compared to Greece for example... if our calculations are correct it's funding will be more expensive but it will still be able to fund itself, Meissner said.

Belgium has been living without a government for months and Belgium can still turn to the market.

GROWTH MOMENTUM

The recent devastating events in Japan and the tensions in the Middle East have left economists pondering what impact the strains will have on global growth.

Stark said that the effects of recent events need to be considered. Nevertheless, recent growth signs had been good.

Incoming data confirm a positive underlying momentum of economic growth and indicate that it is increasingly self-sustaining, he added.

He also rebuffed fears that hiking interest rates could be a set-back for the euro zone's fledgling recovery: Would interest rate hikes harm economic growth in the euro zone? Considering the root causes of the crisis, I don't think so.

It is up to governments to boost growth and employment by restoring the public's and financial markets' confidence in the stability of the financial system and the sustainability of public finances, he added.

(Writing by Marc Jones; Editing by Ron Askew)