The ECB is heading for its most risky move yet

Next Thursday, the ECB will most likely increase its interest rate by 25 basis points to 4.25 percent. Its president Jean-Claude Trichet has all but pre-announced this move and other members of the governing council have been busy underlining the message over the past weeks. This move could prove to be the most risky move ever done by the ECB – economically as politically.

From an economic point of view, the rationale for this move is rather weak. According to business surveys published last week, the euro-area economy has been close to stagnation in June and is heading for a further slow-down. According to purchasing managers in the manufacturing sector, the sector has contracted for the first time in years. The ifo-index for the German busincess climate marked a sharp drop, with the forward-looking business expectations falling to the lowest level since 2005 – the time just before the country started to recover from its long slump. Business confidence is even worse in Spain, Italy or France. Moreover, in several countries, including Spain, Italy and Ireland, unemployment is now clearly on the rise. Spain and Italy either are already in recession or will slip into recession over the coming months.

All this should be enough to prevent second-round inflationary effects from the oil price shock of the past months. Unions are just not going to push for high wage increases in the wake of a slowing economy and increasing unemployment. Moreover, as core inflation in the euro-area does not show any sign of picking up yet, but inflation stemming exclusively from increased energy prices, the economic wisdom of getting headline inflation down quickly by interest rate hikes is highly questionable.

Adding another interest rate hike in this environment might help the economy reaching the inflation target of “below, but close to 2 percent” slightly earlier than it would otherwise be the case – but only at the expense of a greatly increased risk to economic growth.

This is politically highly dangerous for the ECB. If the ECB moves now in such a visible and controversial way, blame for any accidents that might happen to the euro-economy over the coming months will be put to the ECB. If the euro-area should fall into recession next year, the camp of ECB-bashers will definitely find more supporters. Especially if the US economy starts to recover into 2009 while Europe’s economy slows further, a number of people will – with some justification – ask whether the ECB really managed the fallout of the credit crisis well.

Moreover, this move might actually increase the euro-scepticism in countries which are going to experience a recession now anyway. In Ireland and Spain for example, many mortgages are directly linked to LIBOR. With LIBOR actually already performing a jump after Trichet pre-announced the interest rate increase at the last ECB press conference, the Irish and Spanish households will directly feel the pain.

What is worse, these people will know where to put the blame. When I was at a conference in Dublin (see here) and arrived on the day of the last ECB meeting (about ten days before the Irish Lisbon referendum), the taxi driver from the airport was talking about Trichet hinting at an interest rate hike. In Berlin, you would probably not find a single taxi driver who exactly knows what the ECB is doing, much less what its president has said in the last press conference. So, the Irish will directly draw the link from higher mortgage payments to European decision makers in Frankfurt – and possibly to the European integration process as a whole. So long, criticism of the euro and a debate on a possible exit has come mainly from Italy. The ECB is now preparing the ground for similar discussions in other countries.

The ECB board seems to forget that even a legal guarantee for independence in a multinational treaty is only as good as the political support the central bank has in the population. After all, countries can always leave a currency union. Other countries have reneged on constituional guarantees of their exchange rate regimes or multilateral treaties on fixed exchange rates. The most important element of central bank independence is not the legal environment, but the political culture and the people’s trust in the central bank. If a central bank gambles away this trust, it will in the long run also lose its independence.

This post has been co-posted at Eurozone Watch.

8 Responses to "The ECB is heading for its most risky move yet"

  1. Edward Hugh   June 29, 2008 at 2:09 am

    Hi Sebastien,"This move could prove to be the most risky move ever done by the ECB – economically as politically."I absolutely agree. As Claus says, the timing is "impeccable" here."From an economic point of view, the rationale for this move is rather weak."Certainly, but isn’t this part of the problem they have, since they seem to have focused all their attention in recent months not on the data, but on "steering expectations" and communicational issues, and hence they have rather boxed themselves into a corner at this point, a situation which, as you suggest, may well be to the long term detriment of the ECB as an institution. They are rather hamstrung by their charter though, since it is very difficult for them to prioritize growth over inflation given the way they were set up. "All this should be enough to prevent second-round inflationary effects from the oil price shock of the past months." Again, I tend to agree. Spain seems to be the worst case scenario at the moment with the flash June HCPI reading coming in at a record 5.1%, and Q1 nominal hourly labour costs rising at 5.9% y-o-y, even as the economy slows at an alarmingly rapid rate. But if we look a little further forward, to try and see what happens next, Spain seems to be almost inevitably facing – given the constraints of eurozone membership and the relatively strong euro – a sharp downward correction in wages and prices at some point. So from excess inflation we might well be into outright deflation, and I think they would do well to at least reflect on this possibility over in Frankfurt, since the ECB was certainly not devised to administer a Japan style ZIRP or helicopter money for one individual country.On the expression "price shock", something inside me baulks at this, since one of the characteristics of shocks (in terms of the tradition) is that they are considered to be exogenous (as was for example the OPEC cartel rise), while what we are seeing now – at least from a global economy perspective – seems to be much more endogenous, with the the exit of funds from the OECD economies feeding growth in the BRICs etc, and this in turn pushing up prices given the short term resource constraints, and these price rises further choking off growth in the OECD, etc.So basically here in Europe we seem to be getting hit on two fronts at the moment, the credit crunch (stricter lending conditions) and emerging-economy-growth driven price rises, and I don’t see this tonic changing seriously in the short to mid turn.So while criticising the ECB with one hand, I would sympathise with them with the other, since this combination is pretty hard to handle. Of course having a fairly "wooden" discourse doesn’t help them any in their task.

  2. eparisi   June 29, 2008 at 9:11 am

    @ Edward Hugh: "..may well be to the long term detriment of the ECB as an institution.."I would rather say: it may well be to the long term detriment of the EMU economies. Where are the checks and balances?

  3. Berlin Taxi driver   June 29, 2008 at 12:27 pm

    Dear Sebastian,I wonder if my colleague in Dublin also informed you about his declining profits..My impression is that you are confusing some facts. I thought the UK economy is in deep shit, but euro economy is still doing somehow better.I am only an East german taxi driver without ECON101 knowledge. Sorry for the stupid question, but why is it that those EU countries with lots of British tourists´ cash are in decline. Maybe you are exporting some of your Anglosaxon speculation? Or something else? Your answer is highly appreciated.Have to make cash now (i.e. EURO, still a HARD CURRENCY, different to USD or BP). Best.

  4. Guest   June 29, 2008 at 6:44 pm

    Hi Eparsi,"I would rather say: it may well be to the long term detriment of the EMU economies."Point taken. But again, if the ECB loses its credibility as an institution which is able to handle the sort of complex problems which now exist in the Eurozone then that will also be to the long term detriment of the EMU economies, so for better or worse we are all in this together."Where are the checks and balances?"Well this would get us into a long and complicated discussion about the whys and wherefores of central bank independence. The only thing I would like to say on that at this point is that one of the smartest moves Lula da Silva seems to have made in Brazil has been to give almost complete independence to central bank governor Henrique Meirelles. As a result Brazil debt is in the process of achieving investment grade, an investment grade which Italian government debt could so easily lose (see article coming up here tomorrow) if the ECB ceases to have the sort of independence it currently has. So this is a pragmatic question, of what you are prepared to swap for what. Most of the problems facing the Eurozone economies go well beyond a possible quarter point raise or reduction this week, so it won’t be the end of the world one way or another, and since the credit crunch is more a state of mind than a given rate of interest, apart from a very drastic Fed style reduction in interest rates – which surely wouldn’t be justified at this point given the general inflation context – the sorry truth may well be that there ain’t a lot they actually can do, apart from help the banks with liquidity issues which they are already doing.Frankly I don’t think it would enter Lula’s head to critcise Meirelles the way Zapatero tried to "tick off" Trichet after the last ECB meeting.

  5. Edward Hugh   June 29, 2008 at 6:46 pm

    Sorry, that last comment was me.

  6. eparisi   June 29, 2008 at 9:28 pm

    Hi Edward,thanks for your reply, I appreciate the interaction on this blog very much. I would like to point out though that we can’t call the credit crunch a mere state of mind in the face of $400bn losses in the global banking system of which more than half are carried by European banks. And the housing cycle in Europe has just started to turn. Interbank spreads for Euro loans over 3 months are around 100bp last time I checked and the ECB’s mere threat of hiking rates lead to an inversion of the yield curve which is additional bad news for banks. What I’m saying is that a 25bp hike by the central bank may well translate into a multiple of that to the end-consumers, which is like pouring oil into the fire at this stage of the cycle.

  7. Edward Hugh   June 30, 2008 at 1:02 am

    Hi again eparisi,"I appreciate the interaction on this blog very much. I would like to point out though that we can’t call the credit crunch a mere state of mind in the face of $400bn losses in the global banking system of which more than half are carried by European banks."Well when I say the credit crunch is a state of mind, I wouldn’t call it "mere". This state of mind constitutes a fundamental shift in lending conditions. When the guy or gal sitting across the table from you is much more prudent about how much they are willing to lend (the loan to value, or LtV) for how long, or what multiple of your monthly income you can borrow, then this has important consequences at the macro economic level, especially in those countries which were driving economic growth by raising bank lending to households by large percentage points over GDP growth without the domestic savings to back this (which means the US, the UK, Ireland, Spain, Australia, New Zealand, possibly Greece, possibly Denmark, and of course most of the emerging economies in Eastern Europe. Germany and Austria are most exposed to the credit crunch via this transmission mechanism I would say. In the German case they need the exports to the CEE countries to get headline GDP growth, while the Austrians are heavily involved in the banking sector, with Sweden a smaller but similar case on a much lower level in places like the Baltics and the Ukraine). In Spain bank lending was increasing at 20% while GDP was rising at 4%. This simple change to bank lending rising at roughly the same rate as headline GDP is bound to have significant consequences of relatively long duration (ie we aren’t going back to the old ways tomorrow), and this is what I am referring to when I use the expression "credit crunch". The $400 billion odd in write-downs you mention is only what Boris Vian would have called the "froth on the daydream", it was the firework display that initiated the main event. On it’s own this would have been a painful shock – ouch – but would have been assimilable without too many longer term consequences. Now the restriction on bank lending (the state of mind, or sentiment) is squeezing real economic activity in the above mentioned countries, and this squeeze will in its turn send more problems back to the banking sector itself with consequences which perhaps it would be better to wait and see rather than trying to guess too much in advance.Of course all of this – and not accidentally – coincides with another change of mindset out in some emerging economies (with India and Brazil being the most evident), and there the lending conditions (or state of mind) have changed in the opposite direction (its not so much that the appetite for risk has reduced, but simply that these two countries are now seen as less "risky" than they were, so economic growth is transiting from a number of key OECD countries to a number of key emerging market ones, and this is produce the resource scramble, since their growth at this point is very resource intensive. Which brings us back to the ECB and the inflation problem. One last point, in my view there is one more shoe to drop on all of this, and that shoe is in Eastern Europe. This is why since 9 August 2007 I have spent most of my time and energy trying to better understand what is happening there.

  8. BJ   June 30, 2008 at 9:22 am

    Cost-push inflation hurts consumers and producers through erosion of purchasing power. In what way is a rate hike going to help?