Tue, Aug 08, 2006 - Page 9 News List

The European Central Bank picks up the pace

By Melvyn Krauss

Buoyant US economic growth, so far, has provided the European Central Bank (ECB) with the necessary global backdrop to raise interest rates from very low levels at a slow and steady pace that limits political friction with euro-zone political leaders but that gets the job done.

That is about to change. The latest anecdotal evidence from the US indicates that the economy is taking a sharp downward turn, which should become manifest in the coming months. Unless the ECB picks up the pace of interest-rate increases now, the goal of interest-rate neutrality may not be politically feasible, jeopardizing achievement of the bank's price stability goals.

The ECB should act with greater alacrity not because there are increased prospects for future growth, but for the opposite reason: the fear that European growth will slow, thus limiting the possibility for future rate hikes. Indeed, even before the sudden downturn in the US economy, a growing number of members of the ECB's Governing Council already had come to the conclusion that accelerating the pace of interest-rate increases was needed if its goal of monetary neutrality was to be achieved.

The key reason is that several recent "reforms" announced by German Chancellor Angela Merkel -- raising the value-added tax, increasing user charges for healthcare, and taxing interest payments as a part of so-called corporate tax reform -- promise to reduce German economic growth, perhaps significantly, next year.

When Germany sneezes, Europe catches a cold. As a result, Merkel's reforms have increased the angst of euro-zone central bankers that the "window of opportunity" for future rate hikes might be closing.

The latest ZEW survey of euro-zone business confidence buttresses these fears. It shows that current conditions are good, but that expectations about future conditions have dropped off significantly. The message for the ECB is clear: make haste while the sun shines. That is exactly what the ECB is doing.

ECB President Jean-Claude Trichet indicated at last month's press conference that the bank planned to raise interest rates by 25 basis points on Aug. 3, not Aug. 31, as expected. This implies an interval of two months between interest-rate moves instead of the three-month interval that has become standard ECB practice in the current interest-rate cycle. The next rate hike in the normalization process is expected in October, two months after the expected August move.

Ironically, the October meeting of the ECB's Governing Council will take place in Paris this year. French politicians have been the most aggressive in putting political pressure on the ECB to relax its interest-rate normalization policy. French Finance Minister Thierry Breton recently warned the ECB about "nasty surprises." Prospective French presidential candidate Nicolas Sarkozy wants the ECB to promote economic growth, not just price stability.

The Paris meeting affords the ECB an opportunity to make a political statement -- its "Declaration of Independence," so to speak -- by raising interest rates on French soil. Trichet already has cleared the way for this to happen. In June, the ECB jettisoned its long-standing practice of not changing rates outside of Frankfurt, increasing them by 25 basis points in Madrid.

Trichet is a clever and resourceful person. But even he might find it daunting to reconcile the conflicting demands of the ECB to accelerate the interest-rate normalization process and those of the French political establishment to maintain the status quo. But the recent good economic numbers coming out of France should make an October rate hike easier for French politicians to accept.

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