Wednesday, March 23, 2011

ECB tightening a done deal

The European Central Bank (ECB) remains poised to raise interest rates when it meets next. Recent events in Japan appear to have not deterred ECB President Jean-Claude Trichet from his hinted-at intention to do so at the central bank’s April meeting. Indeed in an address yesterday to the Committee on Economic and Monetary Affairs of the European Parliament, Trichet said:

“As regards our future monetary policy stance, I have nothing to add to what I said, on behalf of the Governing Council, on the occasion of our last monetary policy decision meeting earlier this month.”

I still think this is a risky strategy for the ECB. The economic recovery is not yet robust across Europe (although it is in some parts) and fiscal policy is set to do a lot of the work of starting to remove highly accommodative policy settings. In many developed countries with high debt levels it is desirable that fiscal policy does as much of the “de-stimulus” work as possible.

Much of the current inflation problem, and not just in Europe, is due to the direct and now indirect (second round) impacts of higher commodity prices. The problem in Europe is not tight capacity constraints. Taking on commodity prices requires a co-ordinated global response that should probably begin with the end of quantitative easing in America.

And remember this is a central bank that inherited its strong monetarist tradition (i.e. inflation is always and everywhere monetary phenomenon) from the Bundesbank. You’d think that given anaemic money supply growth in the Eurozone, the ECB would think they have a little time up their sleeve.

But then (I was almost tempted to say “on the other hand”!) there are other considerations. The ECB does enjoy strong inflation fighting credentials, and these should not be given up lightly. At the end of the day, monetary policy has only one contribution it can make to building sustained economic growth and that is to keep inflation expectations well anchored. Also, monetary settings are a long way from “normal” (wherever that is now). A pre-emptive strike at normalising monetary settings could be justified especially in light of emerging wage claims in Germany.

A tightening in April seems to be a done deal. But it is not necessarily the case that this will be the start of an aggressive tightening cycle.