Europe set to raise interest rates while Fed holds back

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The euro currency is muscling to a new 14-month high against the dollar Wednesday, as markets brace for an interest rate hike by the European Central Bank on Thursday.

In a controversial move, the ECB is expected to raise its benchmark short-term rate to 1.25% from 1%, the first increase since mid-2008.

Like the U.S. Federal Reserve, the ECB slashed short-term rates during the financial-system meltdown in late 2008 and has held them steady since then as a tool to bail out banks and revive the economy.

Unlike the Fed, the ECB thinks rising food and energy inflation is enough of a problem to justify tightening credit now. The ECB would be following the many emerging-market central banks that began to raise rates last year as food and energy costs jumped. China just tightened credit again Tuesday.

Fed policymakers, by contrast, still are debating what to do next, as the minutes of their last meeting showed. The Fed is continuing to hold its benchmark rate between zero and 0.25% and is buying Treasury bonds in an effort to hold down longer-term rates.

ECB President Jean-Claude Trichet signaled on March 3 that a rate increase was possible at Thursday’s meeting, so this won’t take markets by surprise.

But it’s still giving the euro a further lift. The currency rose to $1.433 on Wednesday, up from $1.422 on Tuesday and the highest since January 2010. The euro has surged from $1.29 in early January.

Higher interest rates tend to attract money to a currency, boosting its purchasing power. But the flip side is that a stronger euro will make European exports more expensive abroad -- another blow to the countries at the heart of the continent’s government-debt crisis, including Greece, Ireland and Portugal.

“Higher interest rates and a stronger euro are bad news for the debt-challenged members of the European Union,” said Ed Yardeni, an economist and head of Yardeni Research in New York.

Some U.S. economists say the ECB may be making a grave mistake if it begins to raise rates, with economic growth still weak in much of Europe and negative in the most troubled countries.

‘In our view, this would dramatically increase the risk of more debt trauma ... and a hard-landing scenario for the euro zone as a whole,” said Michael Darda, chief economist at MKM Partners in Stamford, Conn., in a note to clients.

But that doesn’t seem likely to deter the ECB, which has only one official mandate: keep inflation suppressed, at an annualized 2% or lower. In March, prices were up 2.6% from a year earlier across the euro zone, accelerating from a 2.4% year-over-year rate in February.

For the ECB, that’s enough said.

-- Tom Petruno