Friday, December 02, 2005

The Most Bizarre Monetary Policy DecisionOf Recent Times?

This was Wolfgang Munchau writing in the Financial Times a week ago:

"The pre-announced interest rate rise that the European Central Bank is due to agree this Thursday must rank as one of the most bizarre monetary policy decisions of recent times. The economic recovery in the eurozone remains fragile, as last week’s German confidence indicators have shown. Even the ECB’s own forecast for headline inflation is relatively optimistic, while core inflation remained unchanged at 1.5 per cent in October."

and he issued a warning:

"It is still not too late to propose ECB reform as part of the next treaty revision. For as long as EU leaders maintain the status quo, they have the central bank they deserve."

Central bank independence seems to be once more 'a l'ordre du jour', and the ECB may well live to find to its cost that there is one thing worse than actually playing the game, it's playing the game and losing. Now why?

Well as I try to explain in this post, we really are locked into a very weird at wonderful economic conjuncture right now. The US economy is exhibiting relatively sound and sustainable growth. Germany, Japan and Italy are not. This is producing all manner of imbalances, and this is what the controversy is all about.

Opposition to the decision to raise rates has been pretty universal from eurozone finance ministers, and it has been pretty general from ECB independent economists too. Paul de Grauwe, also writing in the Financial Times thinks it was a simply victory for the policy hawks inside the bank. As he said:

Barely two weeks ago the European Central Bank issued its monthly bulletin containing an analysis of the perspectives for inflation in the euro area. In a nutshell the story was the following.

Yes, yearly inflation has increased to 2.5 per cent (October 2005) and this is a source of concern for a central bank that has promised to keep inflation below 2 per cent. But, as we all know, a central bank that targets the rate of inflation should be forward looking and base its interest rate decisions on the expected future rate of inflation. The remarkable thing about the analysis is that, after voicing its concern about current inflation exceeding 2 per cent, it came to the conclusion that the perspectives for future inflation were favourable.

It is worth quoting the conclusion: “The latest indicators do not point to a strengthening of underlying domestic inflationary pressures in the euro area. Wage increases, in particular, remained contained against a background of ongoing moderate economic growth and of labour market prospects that are still subdued. This assessment is broadly shared by private sector forecasters”. And, indeed, these forecasters almost all predicted and continue to predict a rate of inflation around 2 per cent for the next two years.

The sensible conclusion from this analysis was and still is that there is no reason for a central bank that cares only about inflation (let alone one that cares about other things too) to raise the interest rate. So the ECB correctly concluded two weeks ago that there was no reason for an increase. Of course, it added that vigilance was required, but do we not all have to be vigilant in a world where risks of all kinds lurk around every corner?

So what happened since the beginning of November?

Exactly, what has happened since the 1st November, well, at the risk of being a pain, I would say that the threat of a yield curve inversion in the United States has increased significantly - with the disconnect between US and eurozone growth as the driver - that is what has happened.

As the FT notes, EU politicians are trying to put a brave face on things, but this is uphill work. Perhaps the most significant among the many comments was not the observation from Dominique de Vllepin's politically correct “My belief is that the ECB wouldn’t do anything that would compromise economic growth in the EU.” but rather Christian Noyer - Governor of the Bank of France - saying ``we don't have anything else in our pocket for's not forecast that it's the beginning of the cycle.'' (M. Trichet it will be noted is French, and this decision - and indeed even a bit more of the same - would arguably be quite appropriate for the French economy).

So the ECB 'easing cycle' may well be over, even before it actually got started. My own view is that this has been an extremely foolish move on the part of the Bank, and - as Munchau indicates - they are playing with fire here (as is incidentally and on the other side of the planet the Bank of Japan). If they have read the tealeaves badly (and I think they have) and if the German data fail to improve and the Italian data turn downhill again (which I think might well happen) then this may be the last time the ECB will dare to make a decision which isn't approved of by the finance ministers first.

So was this a balanced risk? Was it wise - or even, god forbid, prudent - to try and call the shots when only a quarter point is in play. I think not. If I was going to make a risky call, one which could threaten my long term independence methinks I would want to do it for something a bit more susbtantial.

But then wishy-washyism has long been one of the defining characteristics of the ECB.

One last, almost anecdotal point, the ECB has, as the FT indicates taken this decision laregy on M3 money supply grounds, viz: "ECB fears had been reinforced by its analysis of money supply figures, which it regards as signalling long-term inflation trends – in spite of scepticism among other central banks".

The scepticism which the FT is referring to is the recent decision of the Federal reserve to stop monitoring M3, which is the key indicator currently used by the ECB. Irony on irony I think.

Many economists have pointed out that, at the end of the day, a quarter point change, even if it's a quarter point in the wrong direction, isn't a make or break issue. Quite right. Let's not get things out of perspective. This won't be disastrous, except, of course, just possibly, for the ECB itself. As Dave Altig says "the ECB has played its hand", fine, but let's just hope that this time next year it is is still in a position to be able to deal the cards.

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