ECB Tightening: Beyond the First Move

March 8, 2011

German Bundesbank President Axel Weber, an unapologetic inflation-fighting hawk, suggested today that the ECB should and probably will implement a series of rate increases during 2011, not just one.  His remarks were made on the occasion on the release of the Bundesbank Annual Report.  Money markets are priced for multiple tightenings, and other members of the ECB Governing Council, for example Bini Smaghi and Nowotny earlier today, have also engaged to tough anti-inflationary rhetoric. 

Next month begins the third tightening cycle since the European Central Bank assumed operational authority over regional monetary policy.  The first of these began with a 50-basis point refinancing rate hike in November 1999 and included six more increases over the ensuing eleven months.  In all, the key interest rates rose 225 basis points from 2.5% to 4.75%.  The second tightening cycle commenced in December 2005 from a lower floor of 2.0%.  That initial move was 25 basis points in size and was followed by seven more 25-basis point increases over the ensuing 18 months and one final hike, also by 25 bps, done in July 2008, eleven months after the onset of the financial crisis and just over two months prior to the failure of Lehman Brothers.  The cumulative increase of the refinancing rate between December 2005 and July 2008 was 225 basis points, same as in the first ECB tightening cycle, and both the first rate increase in December 2005 and the last one in July 2008 were controversial and provocative. 

Often at the start of substantial cumulative central bank tightening cycles, the initial moves are portrayed as preventative steps that do not necessarily foreshadow a whole series of rate increases, and so it was with the second ECB up-cycle of 2005-8.  When the ECB began tightening in November 2000 and December 2005, CPI inflation was at 2.1% and 2.2%, respectively, above but close to 2.0%.  The target of monetary officials is below but close to 2.0%.  Core inflation in the second instance was still well below 2.0% at 1.4%, but the ECB, unlike the Fed, puts greater stress on total than core inflation.  Money and credit growth were elevated when the two earlier tightening cycles began.  Compared to a 4.5% desired rate of M3 growth, such was 6.0% higher than a year earlier in November 2000 and up by 7.6% in December 2000.  CPI inflation of 2.4% currently is higher than it was at the start of the earlier tightening episodes, and the refinancing rate is lower now than then.  But money and credit growth now of 1.7% and 2.0% remain very subdued.

Financial Times commentator Wolfgang Munchau wrote an op-ed editorial yesterday that postulated three obvious reasons for hiking interest rates sooner than had been expected and then offers a hidden agenda behind last week’s hawkish press conference.  Moving the onset of tightening up to April was meant to 1)dissuade worried Germans from any thought that the Axel Weber’s coming resignation will lessen the ECB commitment to price stability, 2) underscore for everybody the separation principle isn’t idle talk and that monetary tightening can begin even if the banking system’s functionality is not yet normal, and 3) promote further euro appreciation, which would be a more effective and speedier way to counter an oil price shock than waiting for higher interest rates to slow down the growth of credit demand, real GDP, and only then pricing pressure.  Although plausible, I find those three factors not terribly compelling in terms of deciding the timing of ECB tightening.  For one thing, the euro right now is actually no stronger than when the ECB announcement was made

Munchau’s suggested hidden agenda, on the other hand, seals the deal for me especially in light of the ECB’s and Bundesbank’s jealous pursuit of policy independence and guaranteeing price stability no matter what the consequences and inconvenience to elected politicians.  Bluntly, the ECB is protesting in the most effective way that it knows how the recent slippage by EU leaders in establishing economic union with automatic and tough penalties that would be implemented immediately whenever a joint float member exceeds proscribed debt and deficit ceilings.  If the national leaders can’t implement a responsible fiscal policy, the central bank will counter-balance that vacuum with monetary restraint that is as tough as needed to get the job done.  Munchau’s theory conjures up recollections of former Bundesbank President Karl Otto Poehl’s resignation in 1991 in protest of the West German government’s plan to unify the D-mark and East German Ost-mark at an uncompetitive 1:1 parity.  Poehl’s departure cleared the path for arch-hawk Helmut Schlesinger to assume the bank’s presidency, and he masterminded a rise of the Lombard penalty rate all the way to 9.75%, more than twice the rate of inflation.  Like Volcker at the Fed a decade earlier, Schlesinger was unwilling to let politician shortcomings undermine price stability.  And now, the ECB is taking no prisoners either in its defense of the same cause.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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