The ECB may be slow to relax monetary policy, but when it gets going, it can move with speed, writes Jim O'Leary
THE BEHAVIOUR of the European Central Bank (ECB) since the global financial crisis began last August has been remarkable. The US Fed has reduced interest rates repeatedly and by a cumulative 3.25 percentage points while the Bank of England has cut base rates by 0.75 of a point. The ECB, by contrast, has not only refused to reduce its interest rates, but amazed observers by hiking them by a quarter-point at its meeting of July 9th.
It's not that the ECB has stood aloof from the turmoil on international money markets. It hasn't. It has pumped record quantities of liquidity into the system, and created innovative ways of doing so, in an effort to keep banks supplied with the cash they need to stay in business.
However, the ECB has drawn a clear and consistent distinction between emergency operations designed to relieve strained conditions in financial markets on the one hand and its monetary policy decisions on the other. The former are determined by the scale and intensity of the day-to-day stress in the banking system. The latter are based, as they have always been, on its analysis of the outlook for inflation and nothing else.
In this respect, the ECB has been on heightened alert for the past several months. Its communications with the public have been peppered with sombre warnings of "upside risks to price stability" and declarations of its firm resolve to "keep medium- and long-term inflation expectations firmly anchored". At times it has seemed that Trichet and his colleagues are living in a parallel universe.
That said, the ECB has an obvious difficulty. Inflation in the euro zone is currently running at 3.6 per cent, well above the official target rate of 2 per cent. It is not easy in such circumstances to square interest rate cuts with the paramount requirement (from the ECB's point of view) to maintain credibility as an inflation-fighting central bank. Still, a slowdown in economic activity in the euro zone, together with the retreat of oil and commodity prices from their recent hyper-elevated levels, holds out the prospect of a substantial fall in inflation in the period ahead. Given that, a central bank whose mandate is medium-term in nature and whose monetary policy perspective stretches well beyond current inflation readings, could perhaps justify loosening things a little. Or so one might have thought.
But that's not quite the way the ECB has been looking at things. At his September press briefing, Trichet acknowledged that economic activity in the euro zone had contracted in the second quarter of the year and conceded that it would probably do so again in the third quarter, but expressed the view that a gradual recovery would get under way in the final quarter and sustain itself through 2009 and beyond. As for inflation, the ECB view, as of September, was that the rate would decelerate towards the 2 per cent target, but very slowly indeed: when pressed, Trichet suggested inflation wouldn't return to the target zone until some time in 2010.
He has also been placing strong emphasis on the risk of second-round effects arising from higher oil prices, by which he means the risk of compensatory wage increases.
It's easy to understand how this kind of view of the world has led to a hawkish policy stance. The problem is with the view of the world. Recently published data paints a picture of a rapidly weakening economy in the euro zone. Little wonder, given what's happening on financial markets and in other parts of the globe. Critically, sharp falls are being recorded not only by barometers of contemporaneous activity, such as industrial output and retail sales, but also by forward-looking indicators like orders and firms' employment intentions. This suggests that recession in the euro area is going to continue for some time. There will be no recovery in the fourth quarter.
In these circumstances, the risk of big wage claims being conceded will recede, and the inflation rate will decline more swiftly than suggested by the Trichet trajectory. Indeed, some analysts believe the fall in oil prices that has already occurred would result in a fall in energy prices sufficient to bring the euro-zone inflation rate back close to its target rate by about the middle of next year.
As of now, the general view among market watchers is that the first cut in ECB interest rates won't occur until early 2009 and that the "refi" rate, currently 4.25 per cent, might be reduced to about 3.5 per cent by the end of next year. As ever, reality will deliver a somewhat different outcome. The key question is where the balance of risks lies.
My own view is that the first cut will come sooner and the cumulative reduction will be significantly greater. When it comes to relaxing monetary policy, the ECB may be slow to start, but when it gets going, it can move with alacrity, as evidenced by the last interest rate cycle: between May and November 2001, the refi rate was cut by 1.5 percentage points. Don't be surprised if a similar pace of loosening occurs this time around.
• Jim O'Leary is a senior fellow of the Department of Economics, Finance and Accounting at NUI-Maynooth. jim.oleary@nuim.ie
