Thu, Nov 03, 2005 page9

• Warning signs of impending inflation abound across the EU

  Despite public and political opposition, the European Central Bank should learn from the US Fed's mistake and raise interest before it is too late

  • By Melvyn Krauss
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  The US Federal Reserve faces a dilemma, for it needs to continue raising interest rates in the face of a hurricane-devastated economy. The Fed's failure to raise rates earlier thus holds a powerful lesson for the European Central Bank (ECB): After a prolonged period of monetary stability at unusually low interest rates, waiting too long to raise rates to more normal and appropriate levels holds dangerous consequences.

  The Fed was late in beginning the interest-rate normalization process, and it is now paying a price. The ECB must not make the same mistake, even bearing in mind that the two central banks operate in different milieus and under different constraints.

  Warning signs of impending inflation abound across the euro zone. Money supply growth has been well above target levels for some time now, indicating excess liquidity. September headline inflation, at 2.6 percent, is above the ECB's 2 percent target, as is the latest forecast for inflation next year (updated forecasts will be released at the beginning of next month).

  "The period of wage moderation may be coming to an end," warns Otmar Issing, ECB's chief economist, implying that soaring energy prices may now be feeding through into the overall price level (the so-called "second-round effects").

  In these circumstances, there is no good reason to wait to raise interest rates. The longer energy prices remain at their current lofty levels, the greater the probability that inflationary expectations will increase and that second-round effects will materialize.

  Further procrastination on interest-rate normalization by the ECB could well lead to a nasty bout of inflation. This would be disastrous for Europe's economic recovery, as the ECB would have no choice but to slam down hard on the monetary brakes.

  No one wants this. Better a 50-basis-point increase now, thereby allowing the economic recovery to continue by keeping inflation in check, than triple or quadruple that figure down the road. The old adage that "an ounce of prevention is worth a pound of cure" applies with particular force to monetary policy.

  Judging from the outcome of last month's meeting of the ECB's Governing Council, that "ounce of prevention" appears to be right around the corner for the euro-zone economy. Indeed, the pace of ECB warnings about the risks of inflation has quickened in recent months -- the earlier "We are vigilant" became "We are particularly vigilant" in September, which became "Strong vigilance with regard to upside risks to price stability is warranted" last month.

  The Governing Council is in danger of running out of adjectives -- as well as credibility -- if it does not act soon.

  The tone of ECB president Jean-Claude Trichet's comments in the question-and-answer section of the press conference following last month's meeting was unusually hawkish.

  Trichet appeared to be calling for a pre-emptive approach when he said, "We must not allow second-round effects to materialize."

  For the first time, the ECB president was willing to admit publicly that the Governing Council had discussed the pros and cons of a rate hike at the meeting.

  Nonetheless, current interest rates were described as "still appropriate" last month, signalling that the ECB has not yet reached a decision to bite the bullet. To be sure, an unexpected slowdown in economic activity or a strong rise in the value of the euro could postpone the inevitable rate hike. But what seems clear is that the ECB used last month's press conference to warn politicians, trade unions and the markets that its long period of monetary-policy inactivity is coming to an end. The exit process has begun.

  Not everyone is happy with this news. Politicians -- like French President Jacques Chirac, Italian Prime Minister Silvio Berlusconi and ECOFIN (the finance ministers of the EU's member states) -- continue to press for fixed, even lower, interest rates.

  But it is easy for politicians to be irresponsible about monetary policy.

  They are not the ones who will be blamed for soaring prices, nor are they the ones who will have to force the inflation genie back into the bottle.

  By constantly pushing for lower interest rates than the ECB can deliver, politicians set the central bank up as a scapegoat for Europe's poor economic performance. Europe is doing badly, they argue, not because of their own failure to lead the structural reform process, but because interest rates are too high.

  At the same time, the ECB does not need to go nearly as far as the Fed, which has raised interest rates in increments of 25 basis points at 11 consecutive meetings, with still more to come. For the ECB, an increase of 50 basis points could do the job at this point -- after which rates could probably be put on hold for some time.

  The Fed waited too long to start the normalization process, and because it was more aggressive in lowering rates in the downward phase of the interest rate cycle, it has had to be more aggressive in raising them in the upward phase.

  This is not the type of volatile monetary policy that Europe wants or needs.

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

  Copyright: Project Syndicate
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