Sunday, January 26, 2003

Is the ECB Rate Drop a Good Decision? It Depends Where You live

As I have been flagging in this column for some weeks now, interest rate policy for the Euro zone is a mess. The most obvious way of indicating this is to say the Duisenberg has no good decision strategy available. Not because he is a good, or bad, banker, but because undecideability is structurally in-built into the problem. The decision is rather whose interests do you favour, the low-inflation or the high-inflation countries. Even if this decision could be seen as mildly helpful from a German, or French point of view, from 'down South' in Portugal, Greece and Spain it looks decidedly risky. For Germany it seems to be a question of far too little, far too late, well behind the curve as they say. Of course, one day the inflation down South will stop. It has to, since they now have no independent currency to devalue in order to recover competitiveness, and, of course, unlike the US they do not have a central bank of their own to start the printing presses rolling. So one day the inflation will turn into deflation as their economies cease to be able to oxygenate and they start to suffer an absence-of-liquidity induced asphyxiation. Meantime we are in a kind of time-void between a decision whose chronicle was already foretold two to three weeks ago (thus there is no real market-shock as it is already priced-in), but whose consequences won't be noticed in any significant sense for six to nine months at least. Bottom line: whatever the long hard winter was which lay in front of Germany as of last Wednesday, well, it still does.

On another front, back in the UK, the consequences for Euro membership of the current interest rate divergence are starting to sink in:

After walking side by side for a while, the European Central Bank and the Bank of England have come to a parting of the ways. It may now be a long time before their paths bring them so close to each other again.In recent years, the gap between the main interest rates of the Bank of England and the ECB has been falling steadily. Last year it closed to just three quarters of a percentage point.Thursday's decisions by the two banks, however, suggested that the impression of convergence between Britain and the eurozone has been illusory......

"The ECB's next move is more likely to be down than up, while the Bank of England's next move is more likely to be up than down," said Robert Barrie of Credit Suisse First Boston. "Inflation is below target in the UK, but potentially going above it, while it is above target in the eurozone but probably going below it." Although both investment and exports have been weaker in Britain than in the eurozone, consumer demand is very much stronger. According to the Organisation for Economic Co-operation and Development, consumption is expected to have risen by 3.6 per cent in Britain this year, supported by a boom in house prices and household borrowing, compared with a mere 0.6 per cent in the eurozone.

The first four years of monetary union have shown that convergence inside it is a slow process. The dispersion of core inflation rates in the eurozone is actually greater now than it was at the euro's birth at the beginning of 1999.For some countries such as Spain and Portugal, real interest rates allowing for inflation are negative. Hence this week's complaint from Rodrigo Rato, Spain's finance minister, that "an interest rate cut is not so great from the inflation point of view". But for Germany, where inflation is low, real rates are still positive although the economy is close to a standstill. "Monetary policy is extremely expansionary in Spain, and extremely restrictive in Germany. It is amplifying the differences between unemployment and growth rates across the eurozone," said Patrick Artus of CDC Ixis in Paris. "If you have a single monetary policy with no significant migration or fiscal transfers, you're in trouble." Whatever the benefits of joining the euro for trade and investment, the risks involved in submitting to the eurozone's single interest rate will make the British government think very hard indeed before joining.
Source: Financial Times

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