The honeymoon for the European Central Bank (ECB) is over. Because European interest rates are no longer clearly out of whack with the fundamentals of the euro-zone economy, monetary policy has become more complex.
At the same time, France has given a strong mandate to its new president, Nicolas Sarkozy, who is without question the most formidable political adversary the ECB has had to face in its brief history. Sarkozy stands ready to pounce on any mistakes the ECB makes in this more difficult policy environment.
With European interest rates up 200 basis points since late 2005 and the euro near a record high, Sarkozy wants the ECB to stop raising rates now. ECB President Jean-Claude Trichet and the Governing Council strongly disagree.
At the ECB press conference early this month, Trichet signaled at least one more rate hike -- either in September or October. Some Council members are known to support two more rate hikes before year-end.
What makes monetary policy tricky at this point is that the German economy -- which has been Europe's locomotive during the current cyclical upturn -- may be reaching a turning point.
Surveys of business and investor confidence have softened -- the respected IFO index of German business sentiment fell from 107.0 to 106.4 this month and the so-called "hard data" -- industrial production, retail sales, etc -- has been mixed. Second quarter German GDP has stalled after a surprisingly strong first quarter.
The jury is out, but there is reason to be concerned. The euro is at record levels, oil prices are surging and interest rates are expected to go higher. The euro-zone economy -- including Germany's -- is not bulletproof, though the hawks in the Governing Council often talk as if it were.
Just as last year when there was unwarranted growth pessimism in Europe, this year there is unwarranted growth euphoria. Many Germans, in particular, are in denial that the cyclical upturn may be coming to an end.
Were the Governing Council to miss the coming turn in the European economy while blithely raising interest rates, they would be portrayed as drunken sailors on a rate-raising binge. The roar for greater political control over Europe's central bank would be deafening -- and not only from France.
The political costs for the ECB of making this type of mistake could be exorbitant. This is why the ECB must be very prudent as it considers whether to maintain the current pace of rate hikes, in which case it would raise rates by 25 basis points in September, or slow the pace down a bit, in which case the next rate hike would come in October at the earliest.
In the current political environment, the dangers to the ECB from outside political interference are much greater from raising rates too fast than too slowly. If it goes too slow, the ECB has earned sufficient credibility as an inflation fighter to make up for it in the future with little if any economic or political cost. But if it goes too fast, the political cost could be substantial and irreversible. Politicians will push for more control and probably get it, Maastricht Treaty or no Maastricht Treaty.
Waiting until October for the next move up is like buying insurance against a catastrophic loss.
But will the ECB see it this way? As a matter of principle, the hawks refuse to consider the political costs of their actions. In earlier times with no formidable adversaries in the political arena, this was a harmless affectation. But it is an extremely dangerous attitude with people like Sarkozy ready, willing and able to impose high political costs upon the bank should it stumble.