Interest rate tightrope

Central bankers on both sides of the Atlantic have a dilemma on their hands. Last week, the Bank of England (BoE) raised its benchmark interest rate to 5.75%. Markets had expected the decision, which was reflected in the sterling being traded up significantly in the days leading up to the decision. A little less than an hour after the BoE decision, the European Central Bank (ECB) announced its decision to keep the main rate on hold at 4% for the time being. But the European bankers in Frankfurt are by no means done tightening monetary policy and this was reflected in Chairman Jean-Claude Trichet's comments during the press conference that followed. Both central banks have now pushed their benchmark interest rates to a six-year high.

In the United States, the Federal Reserve is ahead of the Europeans in its tightening cycle, but the gap between US and European interest rates is diminishing as the Fed now has kept its benchmark rate on hold at 5.25% for a year. Whereas markets show some uncertainty as to the Fed's next move, the BoE and ECB are generally expected to continue their tightening cycles -- both London and Frankfurt are likely to push up rates another notch this year. But as central bankers on both sides of the Atlantic try to bolster their inflation-fighting credentials, they are forced to strike delicate balance. On the one hand, they need to show resolve in the face inflationary pressures that just do want to go away. On the other hand, however, if they tighten monetary policy too far, they could cause an unwelcome overreaction in markets that are increasingly jittery over just how long money will remain cheap.