Jean Claude Trichet, the ECB President, noted in the past for his smooth public style has become uncommonly blunt. The prepared text of today's rate announcement said strong vigilance was needed against inflation. In the distant past, that is before the financial crisis, that was the type of phrase routinely used by the bank to indicate an incipient rate hike. Its sudden reappearance was, for the financial markets, dramatic.

Asked in the post announcement news conference the meaning of the phrase Mr. Trichet said simply, an increase of interest rates in the next meeting is possible. Possible? Mr. Trichet wouldn't have mentioned it if it was not only possible but intended.

Europe's economic recovery is weak. Despite German export strength, the drag that higher rates will place on Spain, Greece, Portugal and Ireland will deepen and prolong their economic plight. The effect of his comment on the credit markets was swift. Spanish 10-year rates gained eight basis points; Greek seven; Portuguese ten and Irish nine. If the ECB is really at the start of a new rate policy these sovereign rates will only continue to move higher

What are the several purposes of Mr. Trichet's blunt surprise?

First, and let us not discount the obvious, inflation is on the march in Europe. It includes food and fuel inflation, which the Fed considers unimportant, but the ECB targets. EMU inflation was 2.3% year over year in January. It has more than doubled in the twelve months from January 2010 when it was 1.0%. The official ECB limit is 2.0%. With the political turmoil in North Africa, inflation is unlikely to subside much over the coming months. Price hikes could engender the second round wage effects that the central bank so fears.

Second, Mr. Trichet's term at the helm of the ECB is up this summer. Alex Weber, the current, that is until April 30th, head of the Bundesbank and former first candidate for the ECB leadership, has resigned from the German Central Bank. Mr. Trichet's statement today puts the anti-inflation mandate back into bank policy. It will now be harder for a new president, whomever it is, to let it slip again. Mr. Trichet has attempted to set the agenda for his successor.

Finally and most importantly, the ECB president has sent a warning to the political leaders of the EMU. Solve the sovereign debt problem permanently. Do not depend on the ECB to prop up debt markets by absorbing unwanted sovereign paper. As a man of great political skill himself, Mr. Trichet knows that letting the central bank do the difficult work of containing the debt crisis, must be a great temptation to Europe's politicians. The bailouts are very unpopular in Germany. Angela Merkel just lost a state election largely on that topic.

The greatest danger to the ECB, the euro and the EMU itself, is to let the sovereign debt issue fester in political limbo because the politicians cannot face their electorates. Mr. Trichet has sent Berlin, Paris and Brussels an unmistakable warning.

Joseph Trevisani
Chief Market Analyst
FX Solutions
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