In Defense of the ECB

October 28, 2008

ECB President Jean-Claude Trichet in Spain yesterday signaled a very strong likelihood, but not a certainty, for a follow-up rate reduction when the ECB meets next week. Amid the debate over the size of the coming cut, many analysts have savagely criticized ECB policymakers for running an excessively tight monetary policy and needlessly allowing the euro area to be slammed by the full brunt of the U.S. economic slowdown. When the ECB raised rates in July, the most controversial move in the string of hikes since December 2005, oil prices were still cresting to a peak above $147 hit later that month. CPI inflation of 4.0% was slightly more than twice as high as the ECB’s target ceiling and on a par with the repo level during 1H08. A variety of measures for expected inflation were creeping higher, too. Few of the ECB’s critics anticipated how vigorously commodity price trends would turn around. Consensus expectations put likely 2009 economic growth in Euroland at 1.5% as recently as June, according to the monthly Economist survey.

Organized labor is more powerful in Europe than the United States, and wage indexation is still quite prevalent there. The ECB is more vigilant than the Fed about preserving price stability not because of some misguided tradition handed down from the German Bundesbank but because inflation containment is harder to achieve in Europe than the United States. It was only during the aftermath of the Lehman failure that the risks of a sharp recession became so much more pressing than the risks of higher inflation, which are now retreating rapidly. What’s done is done. Hindsight shows that ECB policy should have stopped tightening at a lower level and begun to ease sooner, but the path of ECB rates seemed reasonable until fairly recently. Policy now is behind the eight-ball. The real test is how flexibly policymakers react to greatly changed circumstances. I don’t expect the 50-bp rate cut in October to prevent another 50-bp cut at next week’s meeting, and I look for a third reduction in December.



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