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Tuesday, October 03, 2006

Quandry At The ECB

Last week I suggested that the global interest raising cycle may now have peaked. There is an important caveat to this: we may still see one more rise from the ECB this Thursday. (the graphic and the comments below come from the linked FT article by Ralph Atkins).

The ECB really are faced with a hard dilema. They seem to believe that growth in the eurozone is fairly sustainable - even though they recognise that 2007 will not be a strong growth year - and are anxious to raise the level of their refi rate in the longer term. Eurozone politicians, however, undoubtedly see things differently:

How high will the European Central Bank dare to go? Barring upsets, the ECB will announce another quarter percentage point rise, to 3.25 per cent, in its main interest rate on Thursday after its governing council meets in the Banque de France’s imposing Paris building – one of its twice-yearly meetings outside of Frankfurt.

By central bank standards, this will be almost an act of provocation. French politicians, such as Thierry Breton, finance minister, have been among the noisiest in urging the ECB not to jeopardise growth prospects in the 12-country eurozone by raising rates.

The issue is complicated by two factors:

i) The inherent difficulty in running a 'one size fits all policy' for a collection of economies with very different underlying fundamentals.

ii) The obsession the ECB has with the idea that liquidity conditions in the zone are excessively lax (an argument which has been being strongly pushed by MS economist Joaquim Fels who seems to now be pretty influential in Frankfurt):

The ECB can certainly find reasons to push interest rates significantly higher. Credit and money supply figures are flashing red alarm signals: M3, the broad money measure it (unlike other central banks) regards as a good longer-term inflation indicator, remains close to the highest levels seen since the 1999 launch of the euro.

ECB interest rates may be some way from a “natural” rate – judged by economists to be consistent with an economy running at full capacity without generating higher inflation. Estimates occasionally cited by the ECB suggest that the eurozone’s inflation-adjusted natural rate is between 2 per cent and 3 per cent, implying nominal rates (adding inflation) should go as high as 5 per cent.

Caution is likely to be the ECB’s watchword, however. Joachim Fels, economist at Morgan Stanley, argues that the inflation-adjusted natural interest rate might have fallen by a percentage point to around 1.5 per cent in the past decade because of structural changes in the economy and increased central bank credibility.

In practice, such uncertainties make the ECB reluctant to attach much weight to natural interest rate estimates. It prefers to take decisions based on an assessment of medium-term price pressures.

I think Fels exaggerates the underlying inflation problem (although clearly we will all have to learn to live with higher trend energy and commodity prices). Inherent weaknesses will still tend to limit the 'pass through' process, although this will vary from one economy to another. Undoubtedly some zone economies - Ireland, Spain, Greece - have a significant inflation problem, but how do you address this while catering for the needs of those economies with a long run growth challenge (Italy, Germany). Difficult decisions, and what happens on Thursday will be well worth watching.

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