ECB chief's gaffes compound euro woes

"There is no danger to price stability at present, and the euro system does not appear to have committed any major policy errors. However, the euro system does not have a coherent communication strategy, and its actions and motivations are not well understood by the markets." - Centre for European Policy Studies May 2000

Inflation, exchange rates and credibility are the stuff of central banking and we had them all in abundance this week. Credibility is the sine qua non of a central bank. Successful ones like the United States Federal Reserve, the Bank of Japan and even the Bank of England have built up a clear track record, which the European Central Bank has yet to do - hence the above quotation.

The policy studies centre goes on to recommend a number of concrete measures, notably a respecification of the ECB inflation target to make it more obviously a medium-term one and to inject an element of flexibility into it. This is necessary given the widespread view that the current 2 per cent inflation ceiling is too low and too rigid, thereby increasing the likelihood that the ECB will, at some stage, tie itself into a straitjacket as it is forced to push interest rates ever higher in an attempt to meet an unnecessarily strict inflation target.

There is general agreement that recent ECB policy in the form of seven hikes in interest rates amounting to 2.25 per cent in all has been correct, but it continues to suffer from the after-effects of a series of gaffes and contradictory statements by senior board members, notably its president, Mr Wim Duisenberg.

While it is not uncommon for central banks to alert the markets to pending interest rate movements, it is a cardinal rule that they never speak about intervention to support the currency. Intervention, to be successful, must come as a surprise.

This, indeed, was the case in September when the G7 central banks intervened to purchase the euro, causing it to bounce sharply off its lows and stabilise. All of this was lost on Monday when Mr Duisenberg created the double indiscretion of acknowledging that further intervention by the US might be difficult the closer it came to the elections and, secondly, that intervention would be inappropriate if the currency was undermined by turmoil in the Middle East.

The euro immediately fell to new lows and continues to look very exposed. Mr Duisenberg's comments infuriated a range of politicians and central bankers across Europe and were described as "stunningly incompetent" by Mr Jim O'Neill of Goldman Sachs. It is inconceivable that even the most junior central banker in Dame Street would commit such a faux pas and, if one did, he or she would face dismissal proceedings.

Mr Duisenberg's appointment as president of the ECB, it will be recalled, came in the midst of an unseemly row and an apparent compromise that he would resign half-way through his term in 2002, giving way to Mr Jean-Claude Trichet, governor of the Bank of France. There were many around Europe in the past week who wondered if the changeover should not be accelerated, but Mr Trichet has his own problems at the moment. In any event, politicians' hands are tied, given that the ECB has been designed to be the most independent of central banks, with little or no scope for interference in its internal affairs. Mr Duisenberg is, thus, likely to remain for the time being.

The ridiculous nature of the affair is highlighted by the fact that the focus on the currency by central bankers, politicians and, not least, the markets is out of all proportion to its true importance. In economic terms, the degree of openness of the euro economy in the form of its trade with the rest of the world is much the same as that of the US dollar - i.e. 10-15 per cent - which, in turn, means that the impact of currency movements is of little general significance. (Ireland is an exception in that our trading links with the non-euro world are far greater.)

It is for this reason that one rarely hears Fed officials speak of the dollar. ECB officials initially proposed to take a similar line, but have since fallen into the trap of euro-watching. Little wonder that the common view is the weakness of the euro is, in some way, attributable to the ECB.

Equally disturbing is the fact that, in the public debate, the main yardstick for measuring the success of the euro seems to be its rate of exchange, particularly against the dollar. Ms Sirkka Hamalainen, another board member of the ECB, in a speech at the Institute of European Affairs in Dublin this week, described this as a "very shortsighted and even narrow-minded way of assessing the performance of a project that has far-reaching structural implications for the euro area economies".

The reality, of course, is that the weakness of the euro is, for the most part, a reflection of fundamental economic factors that would have made their presence felt whether or not the new currency had been introduced. The situation has, however, been compounded by the occasional indiscretions of central bankers and politicians such as Mr Duisenberg and the German Chancellor, Mr Gerhard Schroder. So what impact will all of this have on affairs in Ireland? The euro is likely to continue to remain weak for longer than expected, maintaining the excessive competitive advantage that Irish exporters to Britain and the US enjoy.

Combined with energy prices which, irrespective of the outcome in the Middle East, look like remaining high for the foreseeable future, a weak euro will continue to put upward pressure on underlying inflation in Europe.

The ECB, a fledgling institution seeking to establish its credibility in difficult circumstances, and faced with a self-imposed ultra-strict inflation objective, will feel compelled to raise interest rates by more than it otherwise would.

Expectations that official interest rates would go no higher than 5 per cent are, thus, likely to be wide of the mark.

Mr Pat McArdle is head of economic research, Ulster Bank Group. The views in this article are personal.