By Marc Jones and Krista Hughes
FRANKFURT, June 6 (Reuters) - By dropping a blatant hint that a July interest rate hike is on the cards, the European Central Bank is once again betting it knows better than those who fear Europe's economy is heading for trouble.
ECB President Jean-Claude Trichet shocked financial markets and dashed economists' expectations for the next move to be a cut when he revealed on Thursday that policymakers had weighed up an immediate hike in rates and were seriously considering a rise next month.
Analysts are now wondering whether a July hike to 4.25 percent would prove to be a one-off shot across the bows or signal the start of a more concerted efforts to tame inflation.
"The question of course now is, how far are they going to go?" said Merrill Lynch economist Klaus Baader. "I would be surprised if one 25 basis point (hike) will do the job, it's more likely to go through to 4.5 percent."
The ECB is facing the toughest inflation environment in its 10-year history and policymakers including Germany's Axel Weber and Austria's Klaus Liebscher have warned the bank cannot sit on the sidelines as price pressures accelerate.
Although Trichet made it clear not all 21 Governing Council members agreed with the call for higher rates, markets are betting the hawks will win through.
Euribor interest rate futures price in two hikes to 4.50 percent by the end of 2008, effectively assuming the ECB will now complete the tightening cycle begun in late 2005 but derailed in mid-2007 when credit market turmoil struck.
This course of action would mean the ECB -- as it has done in the past -- is gambling on the euro-zone economy turning out to be more resilient than other forecasters expect.
Until Thursday's shock, economists had based predictions for a rate cut this year on expectations growth would nosedive after a stronger-than-expected start to 2008.
Earlier this week the International Monetary fund (IMF) predicted euro-zone growth would drop to 1.25 percent next year and urged the ECB keep rates unchanged, a call echoed by the Organisation for Economic Cooperation and Development (OECD).
ECB staff also trimmed growth projections for next year but Trichet said he thought the slowdown would be shortlived, bottoming out later this year before improving again in 2009.
"The economic fundamentals of the euro area are sound... On a quarterly basis real GDP growth is projected to reach a trough in 2008, before gradually recovering thereafter," he said.
DO YOU REMEMBER THE FIRST TIME?
It is not the first time the ECB has been at odds with economists and global institutional heavyweights.
In late 2005, the IMF and OECD also urged the ECB to wait until the recovery was on solid footing before tinkering with monetary policy. The ECB ignored the advice and raised rates for first time in more than two years.
At the time, and against the grain, the Frankfurt-based central bank was predicting a sustainable recovery with growth close to 2 percent in 2006 and 2007. The figures were later surpassed and the ECB was subsequently proved correct.
Analysts said the ECB was making a similar bet this time, but would likely be proved wrong.
"I think they (the ECB) genuinely believe growth will resume potential at the turn of the year. That's the great divide between them and the market at the moment," said UniCredit analyst Aurelio Maccario.
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