ECB will change its tune but later, not sooner
The high levels of uncertainty are not surprising since the end of the subprime debacle is yet to be seen.
Last week’s trenchant refusal by the European Central Bank to cut interest rates was greeted by surprise and shock by the media and many commentators. On the surface, the ECB inaction appears to be at serious odds with what is happening in the real world and with what the other key central banks are doing.
The key role of the ECB is to ensure inflation in the eurozone is maintained within a range of 0 to 2%. This target is easily understood, but more difficult to achieve. Interest rate change takes up to a year to have its full economic impact. What this means is central bankers have to take a forward looking view on what economic growth and inflation might be like 12 months down the road, before they make a decision today.
From the ECB’s perspective, there is clearly no requirement to adjust interest rates at the moment. The eurozone economy, albeit slowing from high levels of activity, is still pretty vibrant and certainly has none of the problems besetting the US economy. At the same time, inflation is running at an uncomfortably high level of 3.2% due mainly to a combination of high food and oil prices.
However, the ECB is also clearly uncomfortable with recent wage developments in Germany. The other big issue for the ECB is it is coming under pressure from the financial markets and a certain French politician to cut interest rates. Central bankers in general, but particularly those in Frankfurt, do not like to be put under pressure by anybody to cut rates. They like to do things in their own time and in their own manner and not at the behest of external forces.
So that is where we are at the moment. Quite simply the ECB has no interest in cutting rates and is more than happy to observe external and internal developments. However, these developments are still likely to be pointing towards a need for lower rates later this year.
The US economy is in recession and a quick sharp recovery is unlikely, so inevitably eurozone growth will be negatively affected. Indeed the ECB recognises this risk as evidenced by last week’s downward revision to growth forecasts for the eurozone in 2008. At the same time the euro is still gaining ground against the ailing dollar and pound sterling. This will accentuate the pressures on growth.
In trade-weighted terms, which is a measure that tries to factor in the various currencies and countries with which the eurozone transacts external trade, the euro has appreciated by 10% over the past year. Such an appreciation, which has further to run, will inevitably damage the export performance of the eurozone over the coming months and undermine economic growth.
The ECB is not yet terribly concerned by these obvious risks, but the balance of probability would suggest this stance could change, but later rather than sooner. The chances are at least one rate cut and possibly two will be seen later in 2008 or early in 2009.
Central bankers like the rest of us do not occupy a certain world, and this will be reflected in the ECB’s slow conversion to a lower interest rate mentality. It would not be advisable to hold one’s breath but relief should eventually come for Irish borrowers labouring under a debt mountain.
Jim Power,
chief economist,
Friends First
