Sunday, May 11, 2003

Complicated Brain Gymnastics

Seeing the damage that was clearly being done, another of the savants, Otmar Issing, has emerged from the closet to clarify: the key phrase 'close to - but below - 2% should give a 'sufficient margin to guard' against the deflation risk. Of course, the fact that this 2% is an aggregate (of somewhat dubious propriety), and that some countries (Germany, Italy...) are already significantly below that magic number and falling, this detail does not seem to merit too much attention.

The threat of deflation in Europe prompted the European Central Bank on Thursday to soften its inflation objective and redefine its monetary policy strategy. In a move that economists said raised the likelihood of lower interest rates in the future, the ECB said it would aim in future for an inflation rate of "close to - but below - 2 per cent".Its previous formal objective had been simply to keep inflation at 2 per cent or less...............

The ECB took no action on interest rates as a result of its new strategy, leaving its main rate unchanged at 2.5 per cent. The decision to leave rates on hold was widely expected, but the steep rise in the euro to a four year high against the dollar had fuelled hopes that the downward pressure on inflation might encourage the ECB to cut rates. Ken Wattret of BNP Paribas said: "I think the ECB view is that deflation may be a problem, but not in the euro area. I get the impression that the ECB has not really taken in the implications of the rise in the euro." The euro hit a four-year high of $1.1506 on Thursday, up 1.25 per cent from Wednesday's New York close, before falling back in late trading.

Mr Issing said the changes to the ECB's strategy would not lead to a change in policy, insisting that past rate decisions would not have been any different if the clarification had been in place earlier. Nevertheless, economists said the change represented a significant shift for the longer term and could lead to a bias in favour of lower rates. David Walton of Goldman Sachs said the review would bring the ECB's declared strategy into line with its interest rate decisions. "I think they should be commended because they've used this as an opportunity to formalise in words what they've been doing in practice," he said. "They will be aiming at inflation of close to 2 per cent, but you can't keep inflation precisely at that level."
Source: Financial Times

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