ECB flags rate hike, warns against default mistake on Greece

Speaking after the ECB left its main interest rate on hold, president Jean-Claude Trichet said the bank's position on inflation was one of "strong vigilance" -- a code for tightening monetary policy in the eurozone.

"The ECB left little doubt that it will hike its key interest rate from 1.25 per cent to 1.50 per cent at its July meeting," IHS Global Insight chief economist Howard Archer said.

In London, the Bank of England left its key interest rate unchanged at a record low of 0.50 per cent.

Besides the stand on rates, the markets were acutely focused on how the ECB would respond to Germany's latest statement on private investors having to pay part of any new bailout for Greece since they are the two most important actors in a drama that could still end in tragedy for the 17-nation eurozone.

"We would say it's an enormous mistake to embark on decisions that would trigger a credit event," Trichet said, using a market term that denotes an action that would be considered a debt default.

German Finance Minister Wolfgang Schaeuble has called for private banks to forego collecting Greek public debts for seven years as part of a broader Greek rescue plan, a move ratings agencies warn would constitute a de-facto default.

Trichet and other ECB directors say that forcing private investors to take losses on Greek public debt could completely undermine confidence in the country's financial sector and possibly wreak havoc throughout the eurozone.

But he reiterated Thursday that the ECB only excluded "concepts which would not be purely voluntary," which left the door open to some sort of compromise rollover agreement with private banks.

The ECB itself, which holds tens of billions of euros worth of Greek bonds, did not intend to participate in a voluntary rollover, Trichet noted.

He also warned that the ECB would apply strict rules on the collateral it accepts in exchange for loans which could mean cutting a crucial lifeline to Greek banks in the event of a default.

Though it is unlikely the ECB would risk driving Greek banks under, "the fact that Trichet nevertheless showed himself so resolute demonstrates the ECB's resolve," Commerzbank chief economist Joerg Kraemer said.

"The ECB president has gone on a collision course with the German finance minister," he concluded.

But "in the end, it will be eurozone governments and not the ECB that have to decide on any debt restructuring," ING senior economist Carsten Brzeski said.

Greece is saddled with 350 billion euros ($500 billion) in debt and markets have concluded a default in some form is inevitable sooner or later.

In the meantime, the ECB extended an exceptional measure of granting unlimited cash loans to eurozone banks at fixed rates until at least mid-October.

The decision means that weakened banks in Greece, Ireland and Portugal, the three eurozone members bailed out by the EU and International Monetary Fund, will have ample access to cash until the end of the year.

It underscored how bank policymakers have separated monetary policy aimed at curbing inflation via its interest rates from non-standard tools designed to support struggling eurozone banks.

Trichet also presented new ECB staff forecasts for eurozone growth and inflation in 2011 and 2012.

They now see growth of 1.9 per cent this year and 1.7 percent in 2012, along with inflation of 2.6 percent and 1.7 per cent, respectively.