The European Central Bank (ECB) has been under intense pressure to reduce interest rates since the Federal Reserve in the US began cutting its main lending rate at the start of this year in response to an unexpectedly sharp slowdown in economic activity. So far, however, the ECB has refused to follow suit.
As it stands, nominal interest rates in the euro zone are at 4.75 per cent and just 0.25 points above those in the US, even though the Federal Reserve has cut rates by a full two points over the past four months. They are 0.75 points below the level prevailing in Britain, even after the Bank of England reduced rates there by 0.5 points. They are of course substantially higher than in Japan, though interest rates there could never be low enough in the light of that country's dismal economic performance over the past number of years.
Interest rates in real terms (i.e. adjusted for inflation) in the euro zone are just over two percentage points, a little more than half a point above the level prevailing in the US. Real interest rates in Britain, at around 3.5 per cent (based on the Bank of England's target measure of inflation, which is currently running at just under 2 per cent), are significantly higher than in both the US and the euro zone. Let's forget about Japan - suffice it to say that real interest rates there are still positive when it would be preferable if they were negative.
Despite the recent criticism of the ECB, interest rates in the euro zone - whether measured in nominal or real terms - are not significantly out of sync with those in the US. However, that is not the point. From a monetary-policy perspective, what is important is whether the level of interest rates is appropriate to current, and indeed prospective, economic circumstances. Unfortunately, this is a difficult question to answer satisfactorily.
As a starting point, one can consider the present cyclical position of an economy relative to its estimated potential (or trend) rate of growth. In the case of the euro economy, the latter is generally accepted, by the ECB among others, as being around 2 per cent to 2.5 per cent. According to the latest available national accounts data, the economy grew at an above-trend rate in the three months to last December. Growth has moderated this year but at a pace that is probably still close to its estimated trend rate.
In an economy that is currently expanding in line with its trend rate of growth and which has not been operating "too far" above potential for a prolonged period (this more or less characterises the recent performance of the euro economy), it seems reasonable that the stance of monetary policy be broadly neutral (where policy is acting neither to retard or stimulate economic activity). As an admittedly crude approximation, the level of real interest rates that is consistent with such a stance is generally considered to be in line with the economy's trend rate of growth.
On this basis, it would appear that the monetary policy in the euro zone is broadly appropriate, given prevailing economic conditions. Indeed, considering also that the rate of increase in prices in the euro zone is above its target range - for reasons mainly to do with the past behaviour of the euro exchange rate and oil prices - it could be argued that interest rates should be higher.
That they are not suggests that the ECB is already taking into account the impact of the US slowdown on the euro zone. Because of the continuing spillover effects from the US going forward, it is likely that growth in the euro zone will soon dip below the trend rate for a period. This ongoing moderation in the pace of activity will help to offset residual inflationary pressures and will allow the rate of increase in prices to fall back towards its target range.
Monetary policy will therefore have to shift from a neutral to an accommodative stance. The ECB is surely aware of this. It is ready to cut interest rates and quite soon. But all the angst about its failure to do so yet seems way overdone.
It is worth noting that the much-revered Federal Reserve waited some time before it first cut interest rates in early January, despite evidence that the economy had begun to slow. According to the Fed, the hesitation resulted from some lingering fears about the behaviour of inflation.
That is not to say that it was correct in waiting. Many believe - albeit with the considerable benefit of hindsight - that it should have acted earlier. Nor is it to say that the ECB is necessarily correct to proceed with caution, although it is difficult to argue convincingly that it has got it wrong so far.
However, it does demonstrate that, even for an institution with the reputation that the Fed has built, never mind for a new entity like the ECB, the conduct of monetary policy is not a simple task. The Monetary Policy Committee of the Bank of England (established in 1997) encountered severe criticism in the first year or two of its existence - remember all the talk about how its actions were serving to keep sterling too high - but has since emerged with its credibility enhanced.
So the ECB will act shortly, although on the basis of forecasts for economic growth this year the reduction in interest rates is likely to be modest. What about interest rates in the US in the future? The economy is currently operating significantly below its productivity-enhanced trend growth rate of the past number of years. This looks set to remain the case over the rest of the year. The Fed has plenty of room left in the coming months to cut interest rates.
Michael Crowley is an economist. He can be contacted on mjcrowley@eircom.net
