Recovery Could Create Headaches for Europe’s Central Bank

Europe’s collective anguish over Greece was interrupted by some good news on Thursday. German unemployment fell more than expected, while earnings surged for some of the country’s biggest companies.

No one is going to complain about signs of robust growth in Europe’s largest economy, which has 10 times the economic output of Greece. But the recovery of the northern half of the euro zone as the southern periphery sinks deeper into crisis sets up a quandary for monetary policy makers that could increase the already serious tensions within Europe.

If growth in Northern Europe continues to gain during the rest of the year, the European Central Bank in Frankfurt will eventually face pressure to raise interest rates to contain inflation.

But a rate increase could harm Greece as well as Spain, Portugal and other countries with debt problems, raising the high cost of borrowing for governments and business.

The central bank “cannot risk inflation in the euro area for the sake of these three countries,” said Zsolt Darvas, an economist at Breugel, a research organization in Brussels. “They will have to face higher interest rates, and it will be very difficult for them to sort out their fiscal problems.”

That view is commonly held in Germany and countries near it. Another view is that relieving the suffering of Southern Europe should trump trying to stamp out future inflation with a heavy hand.

For the central bank, fortunately, the day of reckoning probably will not come until early next year. With no signs yet that inflation is an imminent danger, most economists do not expect an increase in the benchmark interest rate — it is now 1 percent — until March 2011, according to a Reuters poll.

But Jean-Claude Trichet, president of the central bank, and other members of its governing council face plenty of other tough choices in the weeks and months ahead.How much thir efforts can be successful?

One risk is that the loss of faith in Greek solvency will spread to Portugal and perhaps Spain, threatening another bank crisis and forcing the central bank to act.

The central bank has begun to gradually cut back on the nearly unlimited cash it lent to European banks after interbank lending froze in 2008. But some analysts say they believe the central bank could stop that process or even reverse it.

The bank “may have to go back and reopen some of its unconventional measures,” said Nick Matthews, senior European economist at the Royal Bank of Scotland.

The central bank could also face pressure if the United States Federal Reserve began raising rates. Higher rates in the United States would encourage investors to move assets into dollars to earn a better return, causing the euro to fall even more.

A weaker euro would be good for Greece and European exporters in general by making their products less expensive in foreign markets. But the downside is that a weaker euro would increase the cost of oil and other commodities, which are usually priced in dollars. Higher energy costs would feed inflation, adding pressure on the central bank to raise rates.

For now, that risk seems to have eased after the Fed signaled Wednesday that it was in no hurry to raise rates.

The downgrading of Greek debt to junk status by the ratings agency Standard & Poor’s, and the risk of Moody’s and Fitch following suit, presents a more immediate problem for the central bank. Under the central bank’s rules, that would make Greek debt ineligible as collateral for central bank loans, creating serious problems for banks in Greece that use their holdings of domestic bonds to borrow cash.

“The E.C.B. doesn’t want to be the one to push Greece over the edge,” said Janet Henry, chief European economist at HSBC. “If push comes to shove, they would bend the rules.”

But a shift in policy could also damage the credibility of the central bank, said Mr. Darvas, the economist for Breugel. The central bank has already loosened its collateral requirements to help Greece, despite Mr. Trichet’s insistence that the bank would not tailor policy to specific countries.

The central bank also changed course on whether the International Monetary Fund should play a major role in rescuing Greece. Members of the bank’s governing council first said that Europe could deal with its own problems, then pivoted as they were forced to acknowledge that the I.M.F. was indispensable.

Such missteps notwithstanding, bickering among European Union leaders has underlined the importance of the central bank as the one institution in the euro zone able to move decisively in response to an economic crisis.

Alessandro Leipold, former acting director of the I.M.F.’s European department, speculated that the central bank could stretch its mandate even further if Europe’s politicians were too slow to agree on the terms of a rescue package for Greece.

For example, the central bank could organize a bridge loan to allow Greece to meet its immediate financing needs and avoid a default, Mr. Leipold said. “I don’t know the technicalities but it should be possible,” he said. Other analysts said they thought such a move was unlikely.

Another option, according to analysts at R.B.S., entails the central bank buying government bonds, which the bank has avoided.

The central bank “will defend the region using all the tools at its disposal,” the R.B.S. analysts said in a note on Monday. As global trade recovers, German exporters like Siemens, the electronics conglomerate, and the software maker SAP have reported strong earnings, helping seasonally adjusted unemployment fall to 7.8 percent, from 8 percent.Now let us read more about it.

Economists recall that when Germany was struggling in the middle of the decade, the central bank kept interest rates low even though the policy led to overheated economies in Ireland and other countries. “Then they were setting policy for Germany rather than smaller countries — where conditions were far too loose,” Ms. Henry of HSBC said.

In the coming year, “Germany will feature more prominently than the periphery,” she added. “The E.C.B. has its 2 percent inflation limit, and they will do what it takes to achieve that.”