Rate rise shows there is life in ECB yet

A series of increases is unlikely, writes Marc Coleman, Economics Editor, in Frankfurt

When told that former US President Calvin Coolidge had died, American writer Dorothy Parker was heard to respond: "How can anyone tell?"

Yesterday's rate hike will have only a modest impact on the euro-zone economy. But it is a symbolic sign of life returning to an institution that has, in terms of its impact on the euro-zone economy, been dead for over two-and-a-half years.

The ECB's resurrection was a long time coming. It last changed interest rates in June 2003, lowering them on that occasion to their lowest level in post-war history. And it is around five years since the ECB last raised rates. The good news is that the ECB's decision reflects its view that the euro-zone economy is also beginning to exhibit signs of life (although some might argue this is really just rigor mortis).

According to Eurostat data, real growth in the euro zone's gross domestic product (GDP) - the measure of goods and services produced in the economy in a year - has picked up from 0.4 per cent in the second quarter to 0.6 per cent in the third quarter. And the ECB's latest forecasts for next year imply that real GDP growth will reach 1.4-2.4 per cent next year. The ECB's analysis cites external demand for Europe's goods from China and India, as well as growing corporate investment as reasons for this. But its analysis acknowledges that Europe's modest growth recovery conceals weak domestic demand, and that the outlook for economic activity remains subject to "downward risks relating to higher oil prices, concerns about global imbalances and weak consumer confidence". The upward revision in its expectations for the euro zone's prospects are quite modest.

So is there a danger that it will kill the patient just as it is beginning to convalesce? That was the sentiment expressed by the euro-zone finance ministers when on Tuesday they spoke out against a rate increase. The day before a panel of leading monetary experts also said that Europe's recovery was too fragile to risk interest rates now.

But the ECB feels that present interest rate levels are so low in historical terms, that a slight increase will not put recovery at risk.

Rather it sees the biggest risk to Europe's growth as the failure by member states to reform labour markets and reduce the burden of public expenditure.

Mr Trichet ended his explanation of the ECB's decision with a reference to the Lisbon reform process: "It is important to match ambitious objectives with concrete policy measures and take new reform iniatives." This was a clear answer to political critics of his decision to raise rates which, translated from franglais, roughly reads: "We've done our bit, why don't you politicians stop criticising us and start pulling your weight instead?"

The ECB clearly feels it has done its fair share of heavy lifting to support growth. It feels these efforts have been taken for granted. More importantly increases in oil prices over the summer have turned a virtue into a vice.

Headline inflation is now running at about the ECB's reference rate of 2 per cent. Core inflation, which strips out the effects of energy products and some food products, is lower than 2 per cent. But Mr Trichet was emphatic that this is an unreliable basis for making monetary policy decisions. He looks at headline inflation and does so, he says, because the average European looks at headline inflation. So when his forecasters tell him that inflation could be as high as 2.6 per cent next year, he feels that it is his duty and mandate to act.

Some European commentators will criticise him nonetheless. Few Irish commentators could do so. As far as this country is concerned, the quarter point rise will barely halt the momentum of borrowing, investment and construction. As calculated recently by Davy's, net liabilities of the private sector - private debt less deposits and other assets - is around €45 billion. By a quick and dirty calculation, yesterday's move will withdraw an amount equal to roughly 0.25 per cent of this amount, or just over €100 million. This is a fraction of what Brian Cowen will put into the economy in his budget next Wednesday. And it is an infinitesimally small nothingness compared to the amount of money that the SSIA's will put in from the end of next year.

Perhaps the most important outcome of yesterday's meeting was the following statement, which Mr Trichet repeated three times: "This is not an ex ante decision to engage in a series of decisions to increase interest rates in the future." In other words, yesterday's decision does not mean that the ECB is planning an onslaught of rate hikes. The clear impression given yesterday was that the ECB has just tweaked its policy stance a little. Rate increases are not ruled out, of course. But the ECB appears to be hinting that if governments pursue reform and trade unions agree to wage moderation, it may not have to act too much. The ECB will henceforth help those who help themselves.

One could argue that from Ireland's point of view, it has not acted enough. The latest Permanent TSB/ESRI data on house prices shows house price inflation picking up again towards the end of the year as credit growth surges at thirty per cent per annum. Throw in the SSIAs on top of all this from next October. We may yet have cause to look back on yesterday's decision and regret that it was not taken sooner.