Will the ECB's eurozone rate rise damage growth?

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ECB President Jean-Claude Trichet
Image caption,
The president of the European Central Bank, Jean-Claude Trichet, faces a delicate balancing act

The decision by the European Central Bank to raise interest rates to 1.25% from 1% will come as a surprise to almost nobody.

The bank's intentions had been widely trailed - so as not to risk scaring the markets.

But the news the previous night that Portugal was to become the latest eurozone country to request a bail-out has highlighted the divisions within the single currency.

Some economists have warned that whilst some countries may welcome an interest rate rise, for others it may be the opposite of what they need.

Rising prices

The eurozone economy is increasingly split between those countries that have recovered from the financial crisis and those who are still struggling.

Due to something of a historical and geographical coincidence, the two groups have been nicknamed "the core" and "the periphery".

The core is led by Germany, where the latest official figures showed industrial production rising a further 1.6% in February compared with a month earlier.

At the same time eurozone inflation hit 2.6% in March - significantly above the central bank's target, though well below the rate in the UK.

Economically speaking the core countries account for most of output - so the central bank has to adapt policy to them.

"The level of the base rate, in real terms, is no longer in line with the underlying situation in 85% of the eurozone," said Giles Moec, European economist at Deutsche Bank.

Limit to growth?

The situation looks very different for the economies in the so-called periphery.

The Irish Republic, Portugal and Greece may not account for much of the eurozone's economic output - but they are struggling to match the growth of the core.

All are embroiled in severe austerity programmes which are likely to put further pressure on their ability to grow.

"The periphery right now will need quantitative easing rather than a rate hike," said Marco Valli, chief eurozone economist at Unicredit.

But a rate rise itself will have a relatively minor effect on even these economies.

The governments of Greece, the Irish Republic and now Portugal will see a limited impact on their sovereign cost of borrowing - because they are subject to bail-outs.

On the wider economic Italian bank Unicredit calculate that the impact of a rate cut on GDP will amount to 0.25% over three years.

Image caption,
The Irish property market may suffer with rate rises

The concern instead is that rate increases will damage economic confidence and have a disproportionate effect.

Households, already in significant debt, may be hardest hit.

"They are already buffeted by unemployment, tax increases and social welfare cuts," said Austin Hughes, chief economist at KBC Ireland. "Ireland, Spain and Portugal also tend to have a far greater concentration of variable rate borrowing than other countries."

This means that homeowners will see a greater impact from rising rates and may default on mortgages.

That would mean more trouble for banks.

Export worries

Rate rises may also push up the value of the euro, pushing up the price of exports.

This would make it harder for countries to export their way out of recession.

The ECB is ahead of the Federal Reserve and Bank of England in raising rates - if it continues to do so the euro is likely to strengthen further.

A recent survey by KBC and Chartered Accountants Ireland of Irish financial officers found that 73% of Irish businesses felt a rate rise would be harmful to their prospects.

Money available

But economists point out that the European Central Bank is still making money available to troubled banks in the periphery at special rates.

Since the financial crisis, banks have been able to borrow money at the base rate - now 1.25%.

Before then they had to compete for funds, driving up the cost of borrowing.

This "full-allotment" policy is likely to limit the impact of rising rates on banks.

Ultimately, for those countries in need of a bail-out, the move may not make much difference either way.

"The problems of Portugal are way way more complicated than a 0.25% rate hike, they need external help," says Mr Moec from Deutsche Bank.

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