Europe’s Bank Says Financial Turmoil Largely Over

By Carter Dougherty/nytimes.com
Fráncfort (14/08/07)

The European Central Bank declared on Tuesday that recent financial market turmoil was largely over, a sign that the bank would probably proceed with a plan to increase borrowing costs in early September to curb inflation caused by a rising economy.

The liquidity problems in the last week, which central banks around the world smoothed over with large cash infusions, had led many investors to reassess whether the European Central Bank would tighten credit when it meets Sept. 6.

The president of the bank, Jean-Claude Trichet, said Tuesday in an unusual statement that “market conditions have gone progressively back to normal,” as private lenders were beginning to resume their normal routine of extending credit to worthy borrowers.

Mr. Trichet’s comments were made before markets in the United States fell sharply.

His statement highlighted how, within the European bank, decision makers saw no contradiction in supplying liquidity and then raising rates soon thereafter.

The first measure is short-term and largely technical, intended to strengthen trust among banks that had tightened their overnight lending to one another. But higher interest rates, while they tighten credit, work in the medium term to control inflation, the bank’s main priority.

Still, the bank has left itself an out. This month when Mr. Trichet first hinted at a September rate increase, he emphasized more than usual that the central bank would not “precommit” itself to a rate increase — least of all during uncertain times.

“It still depends on whether we return to stability in the markets,” Kenneth Wattret, chief euro-zone economist at BNP Paribas in London, said of the possibility of a September rate increase. “If we go back to a period of turmoil, it’s hard to believe they would raise.”

The European bank has lifted borrowing costs nine times since the end of 2005, to 4.25 percent. Higher interest rates have helped bolster the value of the euro, causing concern among politicians, mainly in France, that the central bank might be quashing a recovery.

Yet if the European bank abandons plans for lifting rates in September, it could fan concerns that it is privy to bad news not yet made public.

“If the bank now delays its rate increase,” said Kenneth Broux, an economist at Lloyds TBS in London, “it will create suspicions it knows something that the markets do not.”

Data released Tuesday showed that the pace of economic growth in the 13-nation euro zone slowed in the second quarter to 0.3 percent, about half the rate of the first quarter. France and Germany, the two largest euro members, registered 0.3 percent growth in the same period, less than economists had forecast, but in line with the central bank’s prognosis of steady growth that would allow it to raise its benchmark rate by a quarter-point.

Despite the slowing, Axel A. Weber, the president of the German Bundesbank, said that losses related to the collapse of the American subprime mortgage sector would be limited.

IKB Deutsche Industriebank, a small German bank, sent shudders through markets recently when a default gave rise to a government-engineered rescue. But Mr. Weber said other German financial institutions were sound.

“We have confirmed our impression that the increased risks in certain market segments are insulated and that the profit impact for credit institutions is limited over all,” Mr. Weber said. The recent problems at IKB are a one-time case, he said, specific to that institution.

Taken together, the statements by the Bundesbank and the central bank appeared to be a broad offensive aimed at closing the door on short-term concerns and easing the way for stability.

The European bank injected 7.7 billion euros ($10.4 billion) in one-day liquidity into the system Tuesday, a far smaller amount than the 94.8 billion euros it provided Thursday.

Mr. Weber’s statement was aimed at assuring markets that no more surprises along the lines of IKB were in the offing, since markets feared German lenders might be hiding greater losses.