Trichet’s dilemma

Dec 2nd 2005
From The Economist Global Agenda

After leaving interest rates unchanged for more than two years, the European Central Bank has finally raised its key rate by a quarter of a percentage point. The bank is trying to establish its credibility as an inflation hawk, but this may be hard to do without endangering the fragile recovery in some of the euro zone’s biggest economies

CONSISTENCY may be the hobgoblin of little minds, but it is an excellent quality in a central banker. For those entrusted with their country’s money supply, nothing matters more than having financial markets believe, deep down, that their monetary champion stands ready to slay the inflation beast whenever it rears its ugly head.

Over the past two years, the European Central Bank (ECB), the euro zone’s guardian, has had to endure a great deal of criticism from markets over its monotonous monetary policy. Despite an economic downturn from which the zone’s largest economies are only now fitfully emerging, the ECB steadfastly refused to lower interest rates, which have remained at 2% since June 2003.
This drew fire particularly from those dazzled by Federal Reserve chairman Alan Greenspan’s methods for handling the post-boom slowdown: cut interest rates to the bone and hold them there until the danger is well past (see chart). The ECB’s stolid stance, they grumbled, was one of the reasons Europe’s economies were still fragile while America’s was roaring along—revised third-quarter GDP figures released this week show the American economy growing at an estimated annual rate of 4.3%, against 2.6% in the euro zone.

Analysts hungering for action from the ECB have finally got some, though not the sort all of them would like. On Thursday December 1st, the bank raised rates by a quarter of a percentage point, to 2.25%—its first hike in over five years. The move was hardly surprising, as Jean-Claude Trichet, the ECB’s president, had made it clear weeks before that the time had come for a tightening. Figures for November put euro-zone inflation at an annual rate of 2.4%. Though this marks a falling-off from September’s 2.6% peak, it is still well above the bank’s target of roughly 2%. The ECB, a mere seven years old and thus still trying to prove its credibility, moved quickly in the hope of strangling inflation in its infancy, before it poses any real threat to price stability.

But Mr Trichet must tread carefully. Higher interest rates mean a stronger currency, which can hobble the exports crucial to economic recovery in the euro zone. Italy’s current economic woes are due at least in part to its adoption of the euro, which deprived the government of the serial devaluations it once used to keep the country’s labour-intensive manufacturing sector competitive on world markets.

Soon after Mr Trichet’s announcement that higher interest rates were in the offing, the euro began appreciating against the dollar, helped along by signs from the Fed that its “measured pace” of rate increases—which have taken America’s key rate from 1% to 4% over the past 18 months—was coming to an end. Mr Trichet acted quickly to reassure markets that the planned increase did not necessarily constitute a trend. Such assurances calmed the foreign-exchange market, as did a statement from a future member of the Fed’s monetary committee that the bank still had some way to go before easing off on interest rates.

Mr Trichet has to worry not only about the markets, but also about the politicians and interest groups who are vehemently opposed to any tightening. In the days leading up to the rate rise, bankers joined trade unions and business leaders in complaining that higher interest rates would endanger the slow recovery and throw people out of work. On Thursday and Friday, ECB policymakers went on a charm offensive, arguing in a series of interviews that keeping inflation low was the best path to long-term economic growth.

But Mr Trichet also reiterated that he was not planning to keep tightening. On Thursday, after the announcement, he said: “We are not engaging ex ante in a series of interest-rate increases. And as I said, we will continue to monitor closely all developments with respect to risks to price stability.” This was seen as an unusual move for a central banker trying to nip inflation in the bud and keen to cement his credibility as a monetary hawk. But the message kept the euro from leaping against the dollar, and eased some of the public pressure on the ECB. Mr Trichet is undoubtedly hoping that his pre-emptive action will send a more powerful signal to markets than his wishy-washy public remarks. But he is walking a very fine line.

If euro-zone inflation stays well above target, the ECB will probably have to act again, no matter how much this upsets currency markets or politicians. A central banker’s credibility as a hawk is what keeps inflationary expectations at bay. Once such expectations are established, inflation takes on a life of its own, and it can be extremely costly to quell. Paul Volcker, the Reagan-era Fed chairman, had to raise interest rates to nearly 20% in order to establish his inflation-fighting credentials decisively. He conquered the double-digit inflation that had plagued his predecessors, but at the cost of plunging America into its worst economic downturn since the Great Depression.

Europe’s situation is particularly tricky, because the euro zone is not an optimal currency area. Different countries are at different points in their economic cycles—in 2004, Italy’s GDP grew by a mere 1.2%, while Ireland’s increased by 4.5%. These countries no longer have the option of using money supply to control growth, and their scope for loose fiscal policy has been limited, in theory at least, by the Maastricht criteria, which forbid euro-zone members from running budget deficits over 3% of GDP for any extended period.

In practice, Germany and France, as well as some smaller countries, have flagrantly violated this rule. But the Maastricht criteria were supposed to help synchronise the euro zone’s business cycles; gutting the rules will slow the pace of integration. And the European Union has so far proven unable to enact other policies, such as a directive to increase cross-border competition in services, which could provide some of the labour and capital mobility that eases regional disparities in large currency areas like the United States. This presents the ECB with an unappetising choice: slow down the fragile recovery in economies like Italy’s, or run the risk that more robust countries will overheat.

Wrong target

But though many would like to pin the blame for Europe's woes on its monetary policy, the one-size-fits-all currency regime is not the main cause of the euro zone's problems. Its biggest economies are burdened with a number of structural flaws, in particular rigid labour markets. Ill-fitting monetary policy exacerbates these but it does not cause them, and it cannot fix them; only radical—and unpopular—regulatory change can do that. Nonetheless, with euro-zone growth steady but unspectacular, and unemployment still stubbornly stuck above 8%, Mr Trichet would clearly prefer not to have to raise rates again in the near future.

Unfortunately, he may not have a choice. High oil prices feed inflation even as they slow economic growth, and the ECB feels even more pressure than other central banks to establish its hawkish credentials, because it is so young. Europe’s central bank may prize consistency, but it still has other hobgoblins to deal with.

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