Economics: To raise or not to raise. That is the question facing the European Central Bank (ECB) when it meets next Thursday to decide on the future course of European interest rates, writes Paul Tansey
In conditions of continuing uncertainty in global credit markets, it's a tough call. The decision is made all the more difficult as the ECB had previously signalled its intention of increasing interest rates in September.
The ECB is now caught between a rock and a hard place. The rock represents the bank's cast-iron commitment to maintaining price stability. This commitment was reaffirmed by the bank's president, Jean-Claude Trichet, when he addressed the European Economic Association in Budapest last Monday.
He said: "Our mandate is to maintain price stability over the medium term and we have clarified that price stability is to be interpreted as a rate of increase in the harmonised index of consumer prices for the euro area below, but close to, 2 per cent."
Interest rates are the principal weapon in the bank's anti-inflationary arsenal. Where price stability is threatened, the bank will raise interest rates to dampen demand, limit the public's appetite for credit and quell inflationary expectations.
ECB interest rates peaked in October 2000 before commencing a prolonged decline. The need to shore up confidence after September 11th, 2001, and the sclerotic performance of the European economy saw interest rates fall continuously, reaching 2 per cent in June 2003.
Rates remained at this low level for almost 2½ years. However, by the end of 2005, accelerating inflation and a pickup in European economic activity caused the ECB to change course. Rates have risen eight times since then, reaching 4 per cent in June this year.
At first glance, inflation does not pose an immediate threat to price stability. Euro-zone inflation, as measured by the harmonised index of consumer prices, decelerated to 1.8 per cent in the year to July 2007, from 2.4 per cent in the year to July 2006.
However, figures released last Tuesday show that the euro-zone broad money supply (M3) increased at its fastest pace yet in the year to July 2007, rising by 11.7 per cent. Rapid rates of monetary expansion are usually early indicators of rising inflation in the medium term.
Economic growth in the euro zone has remained quite strong in the first half of 2007, led by a renascent German economy. Excess demand pressures are becoming visible, both in terms of capacity constraints and wage drift. Thus, both the economic and monetary pillars on which the ECB bases its interest-rate decisions point to a continuing need to tighten policy.
Following the bank's meeting on August 2nd, Trichet said upside risks to price stability in the medium to longer term required the exercise of "strong vigilance". This coded message telegraphed to the markets that ECB interest rates would be raised in September. Other things being equal, given the pace of monetary expansion, there is now an even stronger case for a rise in rates than existed in early August.
However, other things are not equal. The global credit crisis has intervened. The ECB is now effectively wedged between a requirement to raise interest rates to ensure medium-term price stability and calls to hold interest rates to relieve immediate credit pressures on financial institutions.
The ECB responded to the initial breakdown of trust between financial institutions swiftly and courageously by making available massive amounts of credit at its current refinancing rate. At the beginning of this week, the ECB had advanced €210 billion to the markets through short-term refinancing operations. While this aggressive action has calmed the markets thus far, the crisis is likely to have a long tail.
A decision by the ECB to hold its key interest rate at 4 per cent next week would be cheered by the markets. But while sentiment would improve in the short term, it would do little to address the core problem afflicting financial markets at present. This problem centres on the erosion of trust in counterparties to meet their debt obligations, rather than on the price of money.
The requirements of monetary policy and credit policy are different. The brave - and the correct - decision would be to proceed as planned with the quarter-point increase in interest rates to 4.25 per cent, while continuing to provide as much liquidity as the markets require through open market operations. This would both strengthen the bank's reputation for predictability and act as an anchor on inflationary expectations.
However, the ECB does not want to risk shouldering the blame for any potential economic fallout from the current credit crunch. Trichet created more wriggle-room for himself last Monday by stating that the bank was never "precommitted" to a particular course of action and that prior signalling of a rate rise occurred "before the market turbulences that we had to cope with". The markets promptly discounted further the likelihood of a rate rise on September 6th.
Next week's decision is thus an acid test for the ECB, as it will reveal whether the bank is a worthy successor to the steely Bundesbank or a prey to populism, adept at political risk-avoidance.
