ECB's money tightening raises questions

Friday, August 15

As it celebrates its tenth anniversary, the European Central Bank (ECB) faces difficult policy choices: inflation has reached its highest level in 16 years and the euro-area yesterday recorded its first quarterly contraction since the launch of the common currency in 1999.

Seeking explanations In July, the ECB raised its key interest rate by 25 basis points to 4.25%. The obvious explanation appears to be the fact that since late 2007, yearly inflation measured by the overall harmonised index of consumer prices (HICP) has been well above the ECB's inflation target of 2%, reaching a record 4% in June and July this year. However, the inflation target of 2% is a medium-term objective and the ECB's mandate is "to maintain price stability over the medium-term". Six months of high inflation cannot realistically be considered medium-term.

Another explanation for the move is the ECB Governing Council's overriding and repeated concern that soaring energy prices would translate into second-round effects, by raising economic agents' expectations of permanently higher inflation, thereby leading to higher wage demands. Yet fears of second-round effects have not materialised so far and are expected only for the next round of wage negotiations, which will affect wage settlements in 2009.

This raises the question of whether further interest rate rises (to 5% or more by the end of 2008) would be appropriate. At present, this is unlikely due to the negative euro-area growth in the second quarter (-0.2%) and the deceleration in economic activity projected for the second half of 2008 as well as for 2009. Most forecasters expect 1.5-1.8% growth in the euro-area this year. Should the ECB raise rates again later this year and ignore broadly based economic developments, it would put itself in an unsustainable position by disregarding economic fluctuations, and would probably have to reverse its decisions in 2009.

Inflexible mandate? The ECB's mandate indicates price stability as its primary objective. However, it also stipulates that the ECB should seek to "avoid generating excessive fluctuations in output and employment". Since March 2007, monetary policy has been excessively focused on inflation while the second policy objective seems to have been overlooked.

Concerns have been raised that the ECB tightened monetary policy too much during the first half of 2007 and thus precipitated the downturn in housing markets and in economic growth:

• However, most of the downturn in housing and the economy as a whole was already in the pipeline so that higher interest rates had little (though possibly an accelerating) impact on the economic slowdown. The other question is whether monetary tightening during the first half of 2007 really helped contain inflation at around 2% or whether inflationary factors were moderate anyway.
• Views among central bankers and economists about ECB monetary policy vary widely, but all reject interventions which threaten the independence of monetary authorities. This independence -- as well as that of national banks -- was inscribed in the Maastricht Treaty as a precondition of monetary union.
• French President Nicolas Sarkozy's recent proposals would make the ECB dependent on the politically appointed finance ministers. Such a change, which would require unanimous approval, would de facto end the ECB's independence. Yet France's experience until the mid-1980s shows how monetary policy manipulated by the political elite led to a succession of 'competitive devaluations', a spiral from which the economy escaped only when the overriding goal of disinflation was set and, finally, when the French franc shadowed the deutschmark.

 

Overall, the ECB has been successful at maintaining price stability over the medium term against a background of record and persistently high oil prices. However, the rationale for the monetary policy tightening in 2007 and more recently in 2008 has become less clear. Repetition of the ECB's mantra about second-round effects has become less convincing, while broader economic factors seem to have received less consideration than in earlier monetary policy decisions.