Economics:That the European Central Bank (ECB) will raise interest rates by another quarter percentage point next Thursday is widely regarded as a virtual certainty. Such a move will be the eighth rate hike since December 2005 and will bring the official euro zone interest rate (the "refi" rate) to 4 per cent, up from a 2 per cent trough.
Opinion is divided about what will happen next, but the margins separating the different views are narrow. The optimists think 4 per cent will mark the peak of the current cycle. The mean expectation is that rates will rise just one more time, to 4.25 per cent.
To hold out the prospect that rates might get to 4.5 per cent is enough to earn the stripe of a pessimist. My own view is that 4.5 per cent may well prove to be not pessimistic enough. Here's why.
The upswing of the interest rate cycle can be thought of as comprising two main phases and a kind of transition stage between the two. First of all, there is the accommodative phase, during which rates are low enough that the overall stance of monetary policy continues to stimulate aggregate demand. Typically, through this phase of the cycle, the economy still has plenty of spare capacity, unemployment is high and inflationary pressures are correspondingly muted.
In the other main phase of the upswing, monetary policy becomes restrictive with interest rates rising to levels high enough to ensure that they exert a progressively dampening effect on demand.
Through this phase of the cycle, the economy will be running out of spare capacity, the unemployment rate will have fallen below its long-run average and inflationary pressures will be gathering strength.
Separating these two phases is what might be called a neutral zone in which monetary policy is neither boosting nor restraining aggregate demand. Critically, from the point of view of what follows, interest rates remain in neutral only in a kind of policymakers' nirvana, where economic conditions are just right: output is growing smoothly at its long-run average rate, unemployment is stable at its full-employment rate and inflation is stable at its target rate.
Where in this scheme of things is euro zone monetary policy at the moment? The answer is clear: it is still in the first phase. We know this because Jean-Claude Trichet, the ECB president, has told us so. At the press conference following the bank's meeting in Dublin last month, he said that "our monetary policy continues to be on the accommodative side", precisely the same formula of words as he used to describe it at his March and April press conferences.
Incidentally, before March, the formula of words he favoured was slightly different ("monetary policy remains accommodative") and some commentators took his change in wording to signify an imminent peak in interest rates. On such barely perceptible modulations do financial markets tremble!
That's just a mischievous aside on my part. The real point here is that, with the refi rate at 3.75 per cent, the stance of monetary policy has yet to become restrictive, according to the ECB. Indeed, it has yet to reach a neutral position.
It is likely that a rise in the refi rate to 4 per cent will shift monetary policy into neutral and that this will be signalled by Trichet at his press conference next Thursday.
Failure to provide such a signal would be quite a bearish development, so watch this space: what Trichet says on this score will be at least as important as the rate rise itself.
Let's assume that at a 4 per cent refi rate, monetary policy settings are neutral. Where would this leave the view that 4 per cent will mark the peak in interest rates? Well, effectively the implication would be that there will be no need to shift euro zone monetary policy into a restrictive gear.
At a small stretch, the same can be said of the view that there will be just one further rate hike: if 4 per cent is neutral, 4.25 per cent is probably neutral too, or pretty close to it.
This would make for an unusual interest rate cycle. It would suggest one of two scenarios for the euro zone economy: either the current expansion is just about to run out of steam, or that it is about to embark on a smooth glide path in which output growth and inflation stabilise at rates that are ideal.
The first of these scenarios is not consistent with the current evidence, which shows euro zone activity continuing to expand at a vigorous rate. The second scenario is unlikely ever to be attained anywhere in the real world: it is the policymakers' nirvana described above.
On the basis of available evidence, the overwhelming likelihood is that the stance of euro zone monetary policy will have to become restrictive. Quite how restrictive remains to be seen, but a 4.5 per cent refi rate, barring a collapse of the dollar and/or a sharp rise in bond yields, looks to me like a very modest expectation in this regard.
Jim O'Leary lectures in economics at NUI-Maynooth. He can be contacted at jim.oleary@nuim.ie
