A Tough Play for the ECB

April 26, 2008

The European Central Bank had increased its benchmark interest rate in eight steps between December 2005 and June 2007 from 2.0% to 4.0%. It has tightened monetary policy no further proactively since the global credit crisis began last August, but monetary conditions in the region have become less generous nonetheless as a result of of a strengthening euro and the diminishing functionality of the money market. Since August 17, 2007, the Fed has reduced its penalty discount rate by 375 basis points and the Federal funds rate target by 325 basis points. By leaving its rate unchanged during this span, ECB officials ran a very different monetary policy than did the Fed, which contributed to a 16% rise of the euro from $1.3478 on August 17th to $1.5630 at the close on April 25th. At an annualized rate, the euro climbed 24%.

The ECB has a single policy mandate, which is to secure CPI inflation of less but close to 2.0% in the medium term. Since the euro was launched at the start of 1999, inflation in the region has never been higher than its current 12-month pace of 3.6%. ECB officials are one of few central bankers in the world that still place great importance on money and credit growth as an indicator of future inflation. The Fed, by contrast, doesn’t even calculate U.S. M3 anymore. M3, private credit and private loans posted increases in excess of 10% in the successive years to both 1Q07 and 1Q08. Loans to non-financial corporations are still cresting and posted a 15.0% advance in the year to March. One doesn’t have to be a monetarist to believe that central bankers risk a loss of price stability if they ignore such rapid money and credit growth. But no central bank is an island. For the ECB not to cut its money rates while the Fed is slashing U.S. rates also carries great risk of mistakenly charting Euroland’s economy on a course heading for a stall. The Governing Council of the ECB has a tough assignment. Charged with this difficult task is a Governing Council, consisting of six Board Directors and the presidents of the 15 central banks in countries using the euro. This body of 21 people generally arrives at its decisions by consensus.

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