European Central Bank Tightens for First Time Since July 2008

April 7, 2011

The ECB as expected raised its refinancing rate by 25 basis points to 1.25%.  Such had been at 1.0% since May 2009.  The deposit rate and marginal lending rate were also lifted by 25 basis points to 0.50% and 2.0%, thus retaining a symmetrical 75 basis points spread below and above the refinancing rate.

President Trichet said no decision had been made about any subsequent policy changes.  That’s a standard response, however.  As I indicated in my preview of today’s meeting, a rise of 25 basis points will not accomplish the intended mission of anchoring inflation expectations and avoiding any second-order effects.  Only a game-changing externally generated negative shock will avert more rate hikes in the future.  Today’s action had been signaled in March when Trichet advised “that strong vigilance is warranted.”  That coded language has been used repeatedly to signal a likely rate hike in the following month.  Likewise, today’s statement reverted to saying, “we will continue to monitor very closely all developments with respect to upside risks to price stability.”  In January 2006, one month after the first rate hike in the previous tightening cycle, almost identical language was utilized, except that the sentence then was completed with the additional inclusion four words “in the medium term.”  At that earlier time, Trichet, like today, joked that the increase was not necessarily the start of a series of rate increases, but the ECB went on to implement increases of 25 basis points each at its 2006 meetings in March, June, August, October and December, not to mention also in March 2007, June 2007 and July 2008.  The rate crested at 4.25% but didn’t stay at that level long.

A statement today from Governing Council of the ECB made a number of pertinent points:

  • “It is of paramount importance that the rise in CPI inflation [to 2.6%] does not lead to second-round effects in price and wage-setting behavior and thereby give rise to broad-based inflationary pressures over the medium term.”
  • Inflation expectations so far remain firmly anchored.
  • However, the ECB’s economic analysis now identifies medium-term price risks as being tilted to the upside.  At its March meeting, policymakers had switched the direction of risk from being balanced.  At the same time, growth risks were modified to “balanced” from “slightly tilted to the downside,” and that new characterization was maintained in today’s statement.
  • With a 1.0% refinancing rate, the monetary policy stance was “very accommodative,” and it remains “accommodative” at the new 1.25% level.  That is to say, policy is “lending considerable support to economic activity and job creation.”
  • A clear separation principle is being maintained between interest rate policy that secures price stability and unconventional measures that promote the proper functionality of the money market and enable the interest rate setting to achieve its desired result.  Non-standard measures are intrinsically “temporary.”  No decisions on such measures were announced today, but their retention demonstrates that policy tightening can precede the full removal of all non-standard measures.
  • The baseline economic forecast calls for a continuing recovery with private sector domestic demand “increasingly contributing to economic growth.”
  • As always, officials used monetary analysis to cross-check the conclusions of its economic analysis.  The monetary analysis until recently had indicated that inflationary pressures over the medium to long term should remain contained.  But the conclusion of the monetary analysis now supports higher interest rates:  “While the underlying pace of monetary expansion is still moderate, monetary liquidity remains ample and may facilitate the accommodation of price pressures.” 
  • The proposals on economic governance adopted by the European Council on March 25 “fall short of the necessary quantum leap in the surveillance of the euro area which is needed to ensure the smooth functioning of the Economic and Monetary Union.”  For some time, the ECB has claimed that while monetary union has been successfully implemented, the same cannot be said about economic union.

The ECB made the correct decision in my opinion within the parameters of its mandate and did so by a unanimous vote.  Inflation has been above target since December and increasingly so.  Inflation is likely to remain above target this year and faces greater likelihood of being higher than forecast than of undershooting expectations.  For an institution with a single mission, that’s enough to justify abandoning a record low interest rate setting. 

I do, nonetheless, object to some of the spin that Trichet and his cohorts are putting on today’s action.  The implication that officials have no idea if more rate hikes may be forthcoming is transparent nonsense for one thing.  Also, today’s rate hike will be rightfully deemed controversial by some because the peripheral economies are in or on the brink of renewed recession and in danger of defaulting, the risk of which now becomes greater.  And parts of the ECB message is conveniently gratuitous.  The shifted conclusion of the monetary analysis could have been made any time while a 1.0% record low interest rate was maintained.  When the ECB was formed, officials decided that an appropriate growth rate of M3 over the long term would be 4.5% per annum, and they never backed away from that reference guideline.  Since M3 expanded 7.6% per annum over the decade between 4Q98 and 4Q08, the remark about “ample liquidity” could have been made at any time.  But today’s move, all in all, was the right one for the credibility of the ECB’s word and commitment to ensuring price stability.  It was proper, too, for containing a real inflation threat, which has shown greater recent momentum in Europe and Asia than in the United States.

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



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