The ECB’s mandate says raise rates, but is the ECB’s mandate correct?

The European Central Bank firmly laid its cards on the table at last Thursday’s press conference. Trichet et al are in no mood to risk potential second-round effects of rising wages. According to JP Morgan the phrase ‘strong vigilance,’ uttered by Trichet during his prepared remarks, was used one month prior to all policy moves during the last tightening cycle. Not surprising then that Bunds sold off and the Euro climbed. A 25 basis point hike in April to 1.25% is now all but a done deal.

Critics have weighed in with chants of an impending policy error on the ECB’s part. Whilst accepting commodity price inflation is clearly on the rise, there are limited signs of second round effects. As Jim wrote last month, recent union negotiated wage increases in Germany, Europe’s strongest economy, have proved fairly muted.

It’s hard to argue with claims that rate hikes will merely heap pain on an already embattled periphery. Coupled with structurally high unemployment, fiscal austerity and a seriously damaged banking system, the prospects don’t bode well for growth .

We know that the ECB’s primary and overarching aim is to ensure price stability. As the ECB notes “We… have as our primary objective the maintenance of price stability for the common good.” In fact, the ECB would argue that price stability is a prerequisite for long run sustainable growth and low unemployment. However, as we’ve argued before, if it comes down to a choice between protecting its inflation credentials and growth the ECB will side with the former. Is it right to damage Europe’s growth prospects to tame an inflation rate that currently stands at 2.3%, largely due to factors outside the ECB’s control?

Some argue that the ECB should not be so nervous about losing its inflation fighting credibility. As MPC Member Adam Posen points out in a recent speech, the Deutsche Bundesbank did not lose its anti-inflationary credibility post the oil shock of the late 1970s, despite inflation running above its 2% target for over six years. Posen claims that despite regularly overshooting both its inflation and money supply target, the Bundesbank was able to keep inflation expectations anchored through the “transparency and flexibility of its monetary framework.”

Perhaps the ECB should give serious thought as to whether it could also engineer a similar scenario. The consequences of prematurely embarking on a tightening cycle could prove disastrous for parts of the European Community and beyond; even if they’re only doing their job.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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  1. Trevor Rothermere says:

    I hope not to appear rude, but the recent theme here seems less bond vigilantism and more inflation apologism. Do you really think that rates can be held at emergency levels over 2 years (2 years!) after the peak of the crisis, without a whole heap of undesirable, unintended consequences developing? No one is suggesting that the very first tentative steps towards normalising rates will be consequence-free, but it should be very clear by now that the alternative, that of maintaining emergency-level rates and unprecedented monetary stimulus, are themselves far from consequence free, not least in terms of the central banks in question retaining their credibility.

    Posted on: 10/03/11 | 7:37 pm

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