No pause, please: The word on Europe's interest rate increases

By Melvyn Krauss

Sunday, Dec 03, 2006, Page 9

`The ECB can't go on hold simply because the French -- or anyone else -- are having an election.'

Pressure is building on the European Central Bank (ECB) to pause from further increases in interest rates after the New Year. The ECB must not give in. So far, the credibility of Europe's central bank has been sufficient to firmly anchor inflationary expectations. But to pause now when Europe's economic strength continues at a robust pace carries with it an unnecessary risk to price stability.

Even though this year has been an excellent growth year for Europe, real interest rates -- interest rates expressed in terms of goods and services as opposed to money -- have not budged from the beginning of the year. This means Europe's monetary policy continues to stimulate economic growth despite the fact that, by this month, money rates will have been raised 150 basis points during this year.

With real rates so low historically, a pause at the New Year would be pre-mature.

Some of the pressure for a pause has to do with the French presidential elections this spring. A rate increase during the election period clearly would make the central bank even more of an issue in the French campaign than already is the case. This is not good.

Still, the ECB can't go on hold simply because the French -- or anyone else -- are having an election (though the bank could be sensitive to the need to pick an appropriate month should a rate adjustment be needed during the election season).

Politics must take a back seat when it comes to monetary policy decisions -- otherwise, inflationary expectations won't be firmly anchored for very long.

A second argument put forth for a pause is the increase in the value-added tax (VAT) in Germany from 16 percent to 19 percent at the beginning of next year. The argument for a pause is that the central bank may want to wait and see how much damage, if any, the VAT hike imposes on the German economy before continuing on with the process of rate hikes.

But for an inflation-fighting central bank like the ECB, the risks from a pre-mature pause are greater than those from pausing too late. With the ECB in its current tightening mode, "better too late than too early" must be its rule of thumb.

Finally, and perhaps most important, there is the powerful example of the US Federal Reserve. Because the Fed has decided to pause, there is substantial pressure -- coming both from inside and outside the ECB -- that Europe's central bank follow suit.

The effect of Fed's policies on other central banks should not be underestimated. ECB critics already claim there has been a certain "follow the Fed" quality to ECB monetary decisions, notwithstanding clear differences between the two central banks over the role the money supply should play in monetary policy decisions.

When the Fed dramatically cut interest rates to fight recession, so did the ECB. When the Fed kept interest at unusually low levels for an extended period of time, so did the ECB. And when the Fed decided to exit this strategy and raise rates in a steady and predictable fashion, so did the ECB.

This, by the way, may not be mere copycat, but an attempt by Europe's central bankers, wary of exchange rate volatility, to loosely co-ordinate interest rates to promote stable exchange rates. But stabilizing the euro by following the Fed carries with it an unnecessary risk for price stability.

Europe and the US are at different phases of the business and interest rate cycles. When the Fed paused, the US economy was in a more mature phase of the business cycle -- and the weight of accumulated interest rate increases greater -- than presently is the case in Europe.

This made pausing in order to see whether past rate hikes sufficiently slow the economy to moderate inflationary pressures a good bet for the US.

It is not a good bet for Europe, however, where growth momentum remains strong despite some recent "backing and filling" after the torrid pace of the second quarter, where interest rates remain too low and money supply growth too high.

"No pause please, we're Europeans" is the proper ECB response to those advocating a break after the New Year even if the euro does go up a bit as a result.

Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University.

Copyright: Project Syndicate