Trichet hints at rise in European interest rates next month

In a sign of a more aggressive attitude by the world's central bankers to the threat of rising inflation, the President of the European Central Bank, Jean-Claude Trichet, suggested yesterday that the ECB would be prepared to raise interest rates as early as next month.

At the ECB council meeting, he said the eurozone's central bank was in a "state of heightened alert". He could "not exclude" a small increase in rates next month, and stressed that this was "not certain, it's possible".

However, on this occasion the ECB left rates on hold at 4 per cent, where they have rested since last June.

Financial markets and analysts were shocked by M. Trichet's comments. The euro rose against the dollar, closing up 1.54 cents at $1.5594. Analysts said the ECB would lose credibility if it fails to lift benchmark credit costs to 4.25 per cent in July. At 3.6 per cent, European inflation is higher than in the UK, where it stands at 3 per cent. Both inflation rates are expected to be closer to 4 per cent by the end of this year.

Meanwhile, the Bank of England kept rates at 5 per cent yesterday in a decision that was given a cautious welcome by observers wary about signs of inflation. The Bank issued no statement with its decision, which was widely expected. The minutes of the MPC meeting will be published on 18 May, but the factors behind the policymakers' thinking are easy to detect.

In its Inflation Report last month, the Bank clearly indicated that the pace of rate reductions would become much slower in the face of accelerating inflation. The Governor of the Bank, Mervyn King, said then that "the near-term outlook for inflation has deteriorated markedly over the past three months ... Rising energy and import prices will almost certainly push inflation up further, possibly significantly in the coming months".

The Bank indicated that inflation would not return to target until 2011, and for some months would stay above the 3 per cent level. At that point, Mr King is required to write a letter of explanation to the Chancellor, Alistair Darling. The Governor and his colleagues have referred many times to the difficulties they face in balancing the risks of tipping the economy into a slump and inflation that is too low; or cutting rates by too much to stop inflation and inflationary expectations becoming institutionalised. The combination of stagnating output and rising inflation has been dubbed "the new stagflation".

Some expressed concern at the Bank of England's caution. The TUC said: "This is very disappointing – and simply puts off the cuts that will be needed to keep growth growing."

Most were more understanding. The Institute of Directors said: "All in all, the right call. With the economy weakening, the MPC won't get any thanks for leaving interest rates on hold, but they really didn't have any other choice. Inflation is well above target and rising, and any easing in monetary policy would have undermined the CPI outlook over the next two years – and with it, the credibility of the MPC. We're still some way off the time when the economic slowdown is sufficient to bring inflation under control."

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