Wed, Dec 07, 2005 - Page 9 News List

Interest rate hike could take a heavy toll on eurozone

By Olivier Blanchard and Francesco Giavazzi

It is now clear that the European Central Bank (ECB) views higher interest rates as the right response to rising oil prices. As a result, the ECB risks painting itself into a corner, for the logic behind last week's interest-rate hike implies that more increases will follow -- a series of policy mistakes that will cost the Eurozone economies heavily.

Despite statements to the contrary, no central bank, including the ECB, can simply focus on inflation and ignore what happens to economic activity. Suppose, for the sake of argument, that stabilizing prices came at the cost of a 30 percent unemployment rate. Surely nobody would want that.

The ECB's defenders would say that such an outcome is purely hypothetical -- and irrelevant -- for there is no conflict between stabilizing inflation and sustaining the appropriate level of economic activity.

Price stability, says this view, reduces uncertainty, thus enabling firms and individuals to take the right decisions, so it is good, not bad, for economic activity.

This argument is true -- most of the time. But when an economy faces a major adverse shock, such as a sharp increase in oil prices, then the twin goals of stabilizing inflation and maintaining economic activity conflict, and the central bank's job becomes more difficult.

Think about what stabilizing inflation means in such a context. Firms are likely to pass the increase in energy costs on to consumers by raising their prices. In response, workers are likely to demand higher nominal wages.

If the central bank is to avoid an inflation spiral, it must ensure that the "first round" effects of higher energy prices on inflation do not fuel such "second round" effects.

In an environment where productivity gains and wage growth are already weak, persuading workers to accept a cut in real wages may be tough.

The interest-rate increase decided last week will soon appear insufficient, and will have to be followed by further hikes and a large increase in unemployment.

In order to achieve its inflation goal, the ECB may have to contract activity until workers are, in effect, beaten into submission.

Is there a better way to respond to adverse shocks? The answer from monetary theory is an unambiguous "yes":

Give workers a chance to adjust to higher energy prices, allow for some pass-through of higher prices to wages over time (so that wages adjust more gradually) and make clear that inflation will return to its target range within, say, a year or two.

Such a policy will limit the rise in unemployment, at the cost of only temporarily higher inflation.

So, why is the ECB set on a tougher course? There are three plausible reasons.

First, there has been little wage pressure so far. So the ECB may not have to increase interest rates very much in order to contain inflation. If this scenario plays out, the impact on economic activity and employment will be minimal.

But there are good historical grounds for thinking that it won't. What we are seeing in Europe today is more likely to be delayed adjustment rather than passive acceptance of real wage cuts by workers and unions.

The ECB should not delude itself into thinking that a small increase in interest rates will be enough. If and when wage pressure comes, the ECB, to remain true to its word, may be forced to increase interest rates much more than it now expects.

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