ECB, Bank of England Keep Rates Unchanged on Inflation Concern

By Svenja O'Donnell and Simone Meier

Sept. 4 (Bloomberg) -- The European Central Bank and the Bank of England kept interest rates unchanged to fight inflation as their economies teetered on the brink of a recession.

ECB policy makers meeting in Frankfurt kept the benchmark lending rate at 4.25 percent, a seven-year high. The U.K. central bank's Monetary Policy Committee left the bank rate at 5 percent today in London.

The euro-region economy contracted in the second quarter. Growth stalled in Britain, which may face the worst conditions since World War II, according to U.K. Chancellor of the Exchequer Alistair Darling. The Bank of England has still refrained from cutting borrowing costs and the ECB raised its rate in July on concern higher pay demands may entrench faster inflation.

``They're both inflation-fighting central banks and inflation is well above their targets,'' said Stewart Robertson, an economist at Morley Fund Management in London, which manages the equivalent of $271 billion. ``Growth has weakened a lot and is likely to stay weak. The Bank of England seems to have owned up to this but the ECB hasn't quite yet.''

ECB President Jean-Claude Trichet began a press conference at 2:30 p.m. in Frankfurt to explain today's decision.

Inflation Risks

The ECB decision today was predicted by all but one of 53 economists in a Bloomberg News survey. ECB council members Axel Weber and Lucas Papademos said last week that another rate increase may be necessary if inflation risks increase.

While crude oil prices have retreated 26 percent from a record $147.27 a barrel on July 11, they're still up 46 percent over the past year. Euro-region inflation slowed to 3.8 percent in August from a 16-year high of 4 percent in July. The ECB aims to keep the rate below 2 percent.

Some labor unions are already pushing through bigger wage increases to compensate workers for the higher cost of living. IG Metall, Germany's biggest union, starts wage negotiations this month for 3.2 million metal, electronics and car workers. The union has said it will demand a bigger pay increase than the 6.5 percent it asked for last year.

``IG Metall usually sets a benchmark for wage demands in other industries,'' said Andreas Rees, chief German economist at UniCredit Markets & Investment Banking in Munich. ``It's too early to give the all clear on inflation.''

King's Forecast

In Britain, inflation reached 4.4 percent in July, the fastest in at least a decade. While the bank aims to get the rate down to 2 percent, Governor Mervyn King said on Aug. 13 it will reach about 5 percent later this year and ``a reasonable person'' would expect price increases to stay high ``for a while.''

``Until there is some indication of relief on the inflation front, they are stuck,'' said Neil Mackinnon, chief economist at ECU Group Plc in London and a former U.K. Treasury official. ``But the economy is already in recession and interest rates will have to come down. It's purely a matter of timing.''

The pound fell to a record low against the euro this week after Darling said in an interview with the Guardian newspaper that the U.K. economy may face the worst crisis for 60 years. Gross domestic product was unchanged in the second quarter from the first three months of the year, ending the nation's longest stretch of growth in more than a century.

Difficult `Challenges'

``Looking at it in terms of the challenges facing the authorities, it is as difficult as at any time I can remember,'' former Bank of England Governor Edward George said at an event in London yesterday. He said that Britain and other industrialized nations may face a ``technical recession,'' meaning two consecutive quarters of economic contraction.

U.K. mortgage approvals dropped to the lowest since at least 1999 in July, while surveys by the Chartered Institute of Purchasing and Supply show that services and manufacturing industries contracted for a fourth month in August. House prices dropped 12.7 percent in August from a year earlier, the most since at least 1983, HBOS Plc said today.

In the euro region, confidence in the economic outlook plunged to a five-year low and the manufacturing and service industries contracted for a third consecutive month, indicating the economy may have entered a recession.

While the euro-region economy is weakening, ``it may take the ECB longer to accept that inflation problems have dissipated,'' said Morley's Robertson, who predicts the bank will cut its benchmark rate by 1 percentage point next year. ``They may need to do more,'' he said.

To contact the reporters on this story: Svenja O'Donnell in London at sodonnell@bloomberg.net; Simone Meier in Frankfurt at smeier@bloomberg.net.