Why did the ECB raise interest rates?

Jean-Claude Trichet’s decision at the European Central Bank’s (ECB) at the last monetary policy meeting to signal a rate hike surprised many. Today, after the ECB followed through and raised interest rates, Trichet explained the decision.

The ECB’s mandate is to keep inflation rates “below, but close to, 2 [percent] over the medium term.” The past three readings of euro zone inflation, though, have been above 2 percent.

The key question, then, is if there is a risk that medium-term inflation expectations will become unanchored and inflation will remain above 2 percent.

Trichet thinks there are sufficient risks of it happening, so he raised interest rates in response.

“The adjustment of the current very accommodative monetary policy stance [i.e. raising interest rates by 25 basis points] is warranted in the light of upside risks to price stability that we have identified in our economic analysis,” he said during ECB the press conference.

One, “the underlying momentum of economic activity continues to be positive,” said Trichet. A growing economy is a precondition and ingredient in accelerated inflation. Moreover, it allows Trichet to raise interest rates with limited fear of causing a recession.

Two, there are upside risks to economic growth (i.e. the economy will grow faster than expected), namely a stronger than expected rebound in global trade.

Three, there are threats of higher energy prices (due to the Middle East unrest) and higher taxes (due to efforts in Europe to cut the budget deficit). Both factors will drive up inflation.

Four, while “the underlying pace of monetary expansion is still moderate, monetary liquidity remains ample and may facilitate the accommodation of price pressures,” said Trichet.

In other words, monetary policy remains too loose and may set off uncontrolled inflation.

Trichet said the ECB will “continue to monitor very closely all developments with respect to upside risks to price stability,” meaning interest rates will rise further if inflation isn’t tamed.

Historically, the ECB’s interest rate stood between 3 percent and 4.75 percent.

Trichet also acknowledged that uncertainty remains elevated, meaning the ECB will halt their rate hikes or perhaps extend additional aid to struggling peripheral countries should the euro zone’s economy deteriorate.