The European Central Bank's invisible hand

Gavyn Davies ON the changing of the monetary guard
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"Europe raises interest rates" screamed the headlines and, on the surface, it seemed like business as usual for the Bundesbank last Thursday. The increase of 0.3 per cent in its key repo rate, the first rise in German interest rates for five years, shook the financial markets as in days of old. The rise was explained by the Bundesbank entirely on German domestic grounds. Other central banks dutifully followed, whatever their misgivings about their own economic circumstances. Just another example, it seemed, of the European dog allowing itself to be wagged by the German tail.

But all was not what it seemed. In fact, last Thursday was almost the last hurrah of an organisation which has dominated economic life in post- war Europe, but which is now making active preparations to disappear next year. Far from showing that the Bundesbank remains all-powerful in Europe, last Thursday's moves foreshadowed a new era in which the Bundesbank will become nothing more significant than a local operating arm of the European Central Bank (ECB). It would be going only slightly too far to claim that the changing of the monetary guard has already occurred - that European monetary decisions have already passed to a "virtual ECB" which, as yet, has no officials, but whose invisible hand, guided by the Maastricht Treaty, already dominates affairs.

A crazy statement? Consider the following. In 15 months' time, assuming the single currency goes ahead on time, there will perforce be a single short-term interest rate ruling throughout the European economic and monetary union (EMU) area. (Admittedly, there could still be some very small residual differences between rates in different countries, but these will be tiny enough to be forgotten for present purposes.) At present, there is a gap of more than 3 per cent between the lowest rates in the EMU area - 3.3 per cent in Germany and France - and the 6.5 per cent rates which persist in Italy. Central bankers throughout the Continent now accept that this gap will need to be eliminated by the start of 1999, and freely admit that the only questions are how fast this should happen, and on what compromise interest rate all the different countries should converge.

Everyone therefore concedes that there will inevitably be a significant rise in German and French rates, and a similar decline in Italian and Spanish rates, before very long. None of these changes will be driven by domestic considerations in the countries concerned. More than that, all four of the major continental economies will almost certainly end next year with interest rates which are quite markedly different from the rates required for domestic purposes. This simple fact has a straightforward corollary - since each of the central banks realises that it must soon set rates which converge on the European average, it follows that they can no longer also set the rates which are required for domestic purposes. And this will inevitably apply to the Bundesbank as much as it does to anyone else. Indeed, it already does.

In the current state of the German economy, it is far from clear that the Bundesbank can really justify a rate rise on domestic grounds. Unemployment is not only higher than it has been since the Weimar Republic, but it continues to rise by 30,000 per month. Inflation has ticked up a fraction as a result of the weakness of the mark, but it remains under 2 per cent, and labour costs will actually decline this year by more than 1 per cent.

Monetary growth, trotted out as usual by the Bundesbank to justify the rate rise to the public, does no more than provide a routine fig leaf for a central bank council which needs to dampen political opposition. It would scarcely have been sensible to explain to a Euro-sceptic German public that they are facing higher interest rates at a time of record unemployment solely because Italy and Spain are being allowed into the first round of monetary union. But again, it is only exaggerating slightly to say that this is exactly what has happened.

In theory, it would have been feasible for all European interest rates to have converged downwards until they eventually reached the German and French levels, which were 3 per cent before last week. Indeed, this is exactly what has been happening for the last couple of years. But this is where the invisible hand of the virtual ECB comes in.

The national central banks already realise that the handover process to the ECB needs to be smooth and gradual, without any huge leaps in rates which would destabilise economies and unsettle markets. This implies that the convergence process needs to be quite long and drawn out; and it implies that rates must not simply converge, but converge towards a level which the ECB will find appropriate for the whole of the EMU area in a year's time. Of course, no one knows exactly where this will be, but it will certainly not be anywhere near 3 per cent. More likely it will be at least as high as 4 to 4.5 per cent. Recognising this, the national central banks have already started the necessary programme of convergence.

It is important to realise that this will not necessarily involve any monetary tightening for Europe as a whole. If all national interest rates converge on a level of 4 per cent, the weighted average level of rates in the EU will remain at exactly today's level, and we will will observe a pure process of convergence, with the overall monetary stance of the "virtual ECB" remaining precisely unchanged. This is, in fact, what has happened in the past few months - the easing effect of the cuts in Italian and Spanish rates during the summer was almost exactly wiped out by the tightening effect of the German and French action last Thursday. So far, it is wrong to say that Europe has tightened policy, as so many commentators have been writing over the weekend. The virtual ECB has been sitting on its invisible hands, leaving average European rates precisely unchanged.

To understand what is going on as 1998 progresses, it will be increasingly important to think in these unfamiliar terms, concentrating more on the weighted average of EMU rates, and less on the domestic German rates set by the Bundesbank. Today, everyone in the financial markets knows to the decimal point what the Bundesbank is doing to its repo rate, and almost no one has any clue about the average level of EMU rates the virtual ECB is setting. By the end of next year, possibly even by next May when the starting exchange rates for the single currency will be pre-announced, the situation will be exactly reversed.

As this reversal happens, the Bundesbank will entirely lose its power to set and control the overall level of European interest rates, and will instead be forced to set German rates on a path which neatly converges to whatever rates the real ECB will set on 1 January 1999. In the past, Germany has set interest rates and Europe has followed. Quite soon, Europe will set rates and Germany will follow.

The message of last Thursday is that this quite extraordinary loss of German hegemony - which has always been the real reason why France has always been so obsessed with achieving EMU - has already started.