Memo to ecb: Don’t follow the fed [Archives:2005/894/Business & Economy]

November 14 2005

The current dilemma of the US Federal Reserve of having to continue raising interest rates despite the hurricane-wounded US economy holds a powerful message for the European Central Bank.

After a prolonged period of monetary stability at unusually low interest rates, there are dangerous consequences of waiting too long to raise rates to more normal and appropriate levels. The Federal Reserve, having taken interest rates down to spectacularly low levels)in part, because of misplaced fears about deflation– started the interest rate normalization process too late. Now it must continue to raise rates even though there are signs –like declining US consumer confidence ) that America's economy may be faltering. The ECB must not make the same mistake.

Warning signs of impending inflation abound in the euro-zone economy. Money supply growth has been well above target levels for some time now, indicating a condition of excess liquidity. October headline inflation at 2.5% is above the 2% ECB target — as is the latest forecast for 2006 inflation (updated forecasts come out the first of December). Soaring energy prices threaten to work their way into the general inflation process.

Why wait? Further procrastination on interest rate normalization by the ECB could well lead to a nasty bout of inflation. This would be disastrous, in particular, for Europe's economic recovery. The ECB, in such circumstances, would have no choice but to slam the monetary brakes down hard.

No one wants this. Better a 50 basis point increase now that allows the economic recovery to continue by keeping inflation in check, than triple or quadruple that figure down the road — which could stop the recovery cold in its tracks. “An ounce of prevention is worth a pound of cure” applies with particular force to issues of monetary policy.

Judging from the November meeting of the Governing Council, that “ounce of prevention” appears to be right around the corner for the euro-zone economy.

There has been a quickened pace of ECB warnings about the risks of inflation in recent months)from we are “particularly vigilant” in September to “strong vigilance with regard to upside risks to price stability is warranted” at the October meeting in Athens.

Moreover, ECB president Jean-Claude Trichet recently adopted a more hawkish tone in Athens. For the first time, he was willing to publicly declare the Governing Council had discussed the pro's and cons of a rate hike. He appeared to be calling for a pre-emption of second-round effects when he said, “We must not allow second-round effects to materialize”.

Despite this, at its most recent meeting in November, the ECB continued to describe current interest rates as “still appropriate”– signaling that the bank has not reached the required threshold for action. However, Trichet warned, “we clearly can move at any time. We are making no promises”. At a minimum, the ECB has made it clear to one and all–politicians, trade unions, and the markets– that its' long period of monetary inactivity is coming to an end.

Not everyone is happy with this news. Politicians ) like President Jacques Chirac in France, Premier Silvio Berlusconi in Italy and a number of European finance ministers — continue to press for fixed, even lower, interest rates. It's easy for politicians to be irresponsible about monetary policy. They are not the ones who will be blamed for inflationary indiscretions. Nor are they the ones who will have to put the inflation genie back in the bottle once it escapes.

So what if they are unhappy that rates are on the rise. Wim Duisenberg's celebrated comment on politicians and central bankers– “I hear but I do not listen”– is as relevant today as when he spoke those words.

But the ECB must act in its own uniquely European way and not follow the Fed as it exits its prolonged period of monetary inactivity. The Federal Reserve proceeded to raise rates in 25 basis points increments for 13 straight meetings –with still more to come)after it exited from its prolonged period of low interest rates. A simple increase of 50 basis points could do the job at this point for the ECB)after which rates could be kept on hold for some time.

The Fed waited too long to start the normalization process, and because it was more aggressive in lowering rates in the downward phase of the interest rate cycle, has had to be more aggressive in raising them in the upward phase.

This is not the type of volatile monetary policy Europe wants or needs.

Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University.