EU's necessary defence spending boost makes inflation harder to predict, ECB's Knot says

AMSTERDAM (Reuters) - Europe is justified in increasing defence spending but this will boost debt and make inflation or monetary policy direction more difficult to predict, Dutch central bank chief Klaas Knot said on Thursday.

The ECB has cut interest rates six times since last June but offered few if any signals about future moves, arguing that pervasive uncertainty required vigilance and pragmatic, meeting-by-meeting decision-making.

A looming trade war with the U.S. and the need to boost defence spending to fill the void created by America's retreat are among the key challenges that could have deep and long lasting impact on both prices and growth.

"A temporary exemption of budget rules for additional defence spending is justifiable," Knot, the longest-serving member of the ECB's Governing Council, told a press conference. "But the exemption should really be temporary as public debt levels in the EU are still too high."

Germany is changing its constitutionally-enshrined debt brake to fund more military spending while the EU has also announced plans to relax budget rules on defence expenditure.

While this expected extra spending is likely to boost growth, it has already pushed up borrowing costs, setting off two opposing forces for inflation.

A trade war also complicates the picture. ECB President Christine Lagarde earlier on Thursday argued that a full-blown trade conflict with retaliation could cut euro zone growth by a half a percentage point in the first year while boosting inflation by the same magnitude.

"The uncertainty about the direction of inflation is larger than it has been in a long time," Knot said, arguing that he remained completely open minded about the bank's April policy decision.

Market-based longer term inflation expectations surged on the announcement of the German fiscal package but have been inching down ever since and now stand at 2.15%, still above the ECB's 2% target.

"It is very hard to say where interest rates will go, as it is very hard to say where European inflation will go with all the developments that are happening so rapidly," said Knot, whose term expires this summer.

Investors now see a roughly 60% chance of a rate cut in April but a move by June is fully priced in. Markets then see another cut before the end of the year, taking the deposit rate to 2%.

Knot offered few predictions on the impact of the trade war, arguing that policy was in flux and nothing was certain.

"We have to judge the U.S. administration on its acts, it's not easy to judge them only on their words," he said.

(Reporting by Bart Meijer; writing by Balazs Koranyi; editing by Alexandra Hudson)