Expert View: ECB takes its foot off the gas
Sunday 28 November 1999
After the lowering of the key refinancing rate to 2.5 per cent in April, and with inflation still below its 2 per cent threshold, the ECB's decision reflects a reassertion of its price-stability mandate now that Europe's cyclical economic pickup is under way. Even more than for the US Federal Reserve, price stability is the ECB's primary mandate: economic growth is subsidiary.
While the rate rise may be followed by more moderate tightening next year as extra evidence of inflation and spending emerges, no dramatic shift up is in sight. Eurozone interest rates will remain lower than in the US and the UK next year.
Eurozone annual growth in consumer prices was 1.4 per cent in October against 0.8 per cent in February. Other indicators suggest the best news on inflation is past already, with surveys on price expectations moving up sharply, and oil price rises and the euro's depreciation continuing their influence. The ECB's move will certainly help keep these early indications of inflationary pressure under control, and the outlook remains quite reassuring.
Over the past few months, signs of cyclical rebound in Europe have mounted, with rising investment and relatively robust private consumption. Exports, which had slumped during the Asian crisis, have started to strengthen. This recovery will not be short-circuited by the tightening. Interest rates are still low and the refinancing rate is still 2.5 per cent below the UK base rate, with inflation at a similar level.
Positive sentiment among consumers and businesses is not going to be undercut either - recovery in world demand and a gradually improving continental labour market bode well. At any rate, central bankers are trying to assess the level of interest rate that sustains non-inflationary growth. So any near-term negative impact is more than compensated for by a longer-term non-inflationary growth picture.
A rosy scenario then? Well, probably there are still some risks. Eurozone recovery is expected to boost productivity and cut labour costs. There seems to be no risk of a wage-price spiral, but upcoming wage negotiations in Europe - not least the bellwether round at IG Metall - are key.
The heightened credibility of the ECB should contribute to lower wage settlements. But in the highly regulated European labour market, and with complex socio-political relationships between centre-left ruling coalitions and unions, responsibility may not prevail. Unions could anticipate an inflation risk even higher than the ECB's and go for higher nominal wages instead of focusing on having real wages safeguarded by the Bank.
It is unclear whether the rates rise will have a positive impact on wages, or whether it would have been better to hold off raising rates while sending clear signals about the risk of a substantial tightening under strong wage pressures. Past strategy, at least in Germany, is more the latter, with the emphasis on social cohesion. Indeed, "keeping great vigilance" may be more effective than the pre-emptive strike the Bank has made.
The assumption that oil prices will stabilise around current levels may also be challenged. Opec's discipline on production cuts could become self-reinforcing. The firmer prices get, the less incentive Opec countries have to cheat, so amplifying the supply shortage despite rising demand. If combined with the continuing weakness of the euro, this may eventually generate the much-feared "second-round" effects on prices that could lead to a larger monetary tightening.
Although enhanced competition, deregulation and liberalisation of the eurozone economy are having a positive impact on prices, there may still be enough rigidities to stop the advantages triggered by monetary union from fully showing themselves.
But the most likely economic scenario confirms what Wim Duisenberg, the ECB president, said a month ago to the EU parliamentary committee: "Raising interest rates in a certain situation might be more akin to lifting your foot from the [accelerator] pedal a little bit than to braking the car ... in that way going slower, as going forward is what we all want to do."
n Lorenzo Codogno is head of European economics and interest rate research at the Bank of America in London.
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