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This ECB Decision Is Pure Knee-Jerk

Two things stand out from the European Central Bank's decision effectively to pre-announce a rise in interest rates next month. First is its eagerness to polish up its inflation-fighting credentials after being slurred by Axel Weber and much of the German press and political elite; second is its confidence in the ability of its "non-standard" measures to stop a breakdown of the financial system.

Both may be justified, but the bank's motives may not be of the purest.

Associated Press

German Central Bank Governor Axel Weber in Paris last month.

The ECB's credibility has been under intense scrutiny in Germany as a result of its response to the crisis. That scrutiny has become even more intense since the decision by Mr. Weber effectively to pull out of the contest to find a successor to Jean-Claude Trichet rather than run for the presidency of an institution that he considered too soft on inflation and too soft on profligate governments.

Mr. Weber's planned departure from the Bundesbank next month has put more pressure on the ECB to be hawkish than they would otherwise have been yesterday, both directly and indirectly.

Directly, because of the political imperative in Germany to respond to Mr. Weber's rebuke. Indirectly, because Mr. Weber was the most likely candidate to succeed Mr. Trichet when his contract expires in October. Now the Mario Draghis, Nout Wellinks and Yves Mersches of this world are engaged in a hawkier-than-thou war of words, transparently trying to persuade German Chancellor Angela Merkel that each is the man to defend the German cult(ure) of stability at the top of the ECB now that their own candidate has withdrawn.

That on its own would be no particularly convincing reason to raise interest rates now. Another reason not to do so would be the evidence of its own monetary analysis, on which it claims to put so much emphasis. The last time the ECB began raising interest rates—in December 2005— private-sector credit was growing at 9% a year. In the three months to January 2011, it grew at an annualized 2.1%. Corporate borrowing in particular is still doing little more than flatlining, and household borrowing levels are also well below their historical levels.

In short, for all its sophisticated rhetoric about expectations of inflation rates in the medium term, the ECB has taken an unabashedly knee-jerk decision. Inflation has been above its tolerance threshold of 2% for all of two months, and the central bank is already talking about its first interest rate increase since the collapse of Lehman Brothers Inc. And all because of factors that are completely beyond the control of governments and the "social partners" of management and labor that really drive euro-zone wage policy.

As such, the ECB is acting tough to defend its credibility, but its action is not consistent with much of its traditional message.

If that were all there was to it, it would be hard to avoid damning them for a bunch of posturing pseudo-hawks. Thankfully, that isn't the case. A close look at the ECB's announcements Thursday shows that it isn't preparing to throw the euro-zone's highly-indebted periphery to the dogs in defense of a facile definition of credibility.

Ever since spring 2009, the economy has been floated back to growth on a tide of central bank liquidity and the ECB has balanced price stability against financial stability, hoping that it wouldn't have to raise interest rates before the euro zone could clear up its banking system.

As it became clear that the problems of the banks would take years rather than months to solve, the ECB has had to devote more attention to making sure that no major European bank collapsed, triggering a re-run of the post-Lehman mayhem in 2008.

It has done this with a range of non-standard measures, the most effective (and enduring) of which have been a policy of unlimited lending to banks that can post eligible collateral, and a big relaxation of the definition of eligible collateral itself— effectively lending hard cash against junk paper.

Mr. Trichet has always claimed the standard and the non-standard measures can be operated independently. He has never had to prove this until now.

If, as seems likely, the ECB raises its refinancing rate next month, it will continue to lend unlimited amounts to banks that have no recourse to private financial markets. The big gamble is that market rates in the core countries can edge higher without tipping the periphery into bankruptcy.

That rests on the assumption that simple availability of ECB liquidity is more important to addict banks than the 25 basis points extra on the cost.

For that gamble to pay off, the ECB may have to deploy its other principal non-standard weapon— the purchase of government bonds.

Higher central bank rates will almost certainly bring higher government borrowing costs. For Spain and Portugal in particular, still trying to finance themselves through the market, any rise in interest rates will be hard to stomach. In falling bond markets, yield spreads usually widen, and Portugal will almost certainly need heavy buying from the ECB to keep its 10-year yields below the 7% level that its government thinks is sustainable.

You can argue that such a scenario would amount to the de facto suspension of a single monetary policy for the euro zone.

There would be, more clearly than ever, one policy for the periphery and one policy for the core, irrespective of the actual level of interest rates, and it would create obvious political difficulties in the present climate.

But if you have been arguing that the ECB needs to make at least a tactical retreat from the rigors of one-size-fits-all, then its action is overdue and ycould hardly blame it for doing so.

Write to Geoffrey T. Smith at geoffrey.smith@dowjones.com

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