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European Central Bank To Raise Rates, And Threaten Fragile Economies

In spite of a debt crisis and weak economic recoveries in the so-called periphery countries of the European Union (Greece, Spain, Ireland, Portugal, and others) the European Central Bank (ECB) is expected to raise its short-term policy rates, for the first time in three years, later this week. The nominal goal of increasing rates, now at one percent, is to tamp down inflation, which has risen in Europe as it has in the U.S., from higher energy and food costs.

The news is of interest and concern to U.S. investors and workers, of course -- we have only to look at how the European debt crisis interrupted the U.S. stock market a year ago. If I'm remembering correctly, the Euro debt situation helped send the S&P 500 from about 1200 to about 1000. (Today, brokerage firms are cautioning investors on European stocks.) At this point, the economic recovery is moving along in France and Germany, but the smaller economies are still weak, and that will ultimately show itself in GDP growth, including the export sectors of the U.S. In today's Financial Times, economist Nouriel Roubini observes:

My fear is that tightening by the ECB is going to exacerbate the growth, fiscal and financial stresses of the periphery [countries].
The U.S. and U.K. are seeing the same inflationary pressures -- the most in the U.K., actually, where consumer prices are up over four percent year over year, compared to 2.1 percent here at home. But neither central bank seems ready to raise rates at this point, erring on the side of caution.

The ECB has to walk a tightrope -- tighter money, or accommodation?. While it can follow just one rate policy, growth rates are all over the map. Per Bloomberg:

Germany expanded 3.6 percent last year, the strongest pace in two decades. In forecasting euro-zone growth of 1.6 percent this year, the European Commission predicts expansion of 2.4 percent in Germany, three times the anticipated rate for Spain, where unemployment is above 20 percent, the highest in the region.
Prices are rising all over, as are interest rates -- reflecting higher growth, the benchmark German 10-year bond rate is at its highest in 18 months.

The other challenge the ECB faces is that banks in so many countries are still on the brink, and need the lifeline of low-cost financing to hold together. For instance, last week regulators' stress tests showed that Ireland's banks need $34 billion of additional capital, the source of which is the ECB. So the central bank has to get tough and accommodate at the same time, with the same economies.

The ECB is scheduled to meet Thursday. We'll see more fireworks in the markets then.