Magazine article Modern Trader

The European Balance of Monetary Policy

Magazine article Modern Trader

The European Balance of Monetary Policy

Article excerpt

If there's one thing about European Central Bank President Wim Duisenberg that everyone agrees on, it's the uncompromising quality of the blazing mound of white hair piled high upon his inflation-fighting head. What they can't agree on is the quality of his interest rate policy, which most say is too tough, some say is too soft and almost no one says is just right.

Nearly halfway through the ECB president's inaugural eight-year term, the Dutchman just can't resolve the conflict between his job description and the expectations heaped upon him. That eight-year term, by the way, expires halfway through itself, or next year, under a compromise worked out between the Germans (who got the ECB to locate in Frankfurt) and the French (who got to "share" the ECB's first presidency). Then Duisenberg, a Dutchman, is set to hand off the ECB to Bank of France Governor Jean-Claude Trichet.

Trichet will face the same dilemma: Europe's treaty of unification, the Maastricht Treaty, gives the ECB one mandate, and that is to maintain stable prices. It says nothing of using monetary policy to stimulate growth, which is supposed to come through structural reforms such as privatization and deregulation, or of propping up an ailing currency, except insofar as those activities impact the price of crepes and schnitzel. The ECB has given itself the stodgy inflation target of 2% Europe-wide. That's a tough task in a land where 10% inflation rates have been commonplace for more than a half century.

The 2% goal hasn't been achieved in more than a year, and both consumer and producer prices have been rising of late. The Harmonized Index of Consumer Prices (HICP), an amalgamation of Europe's various inflation indexes, accelerated from 2.6% in March to 2.9% in April to 3.2% in May, largely fueled by the surge in energy prices and other components that have shown signs of cooling. Concurrent with that are a string of disappointing growth reports, especially from Germany and France. Torn between creeping inflation, dwindling growth and increasing unrest among unions, Duisenberg and other bank officials repeatedly said a rate cut was too risky.

Then came May 10, when both the ECB and the Bank of England (BoE) cut their prime lending rates 25 basis points. Instead of a pat on the back, Duisenberg was slammed for failing to telegraph his intentions, which critics say makes the bank unpredictable and places a risk premium on European assets that offsets the benefits of any cut. BoE operatives, on the other hand, had telegraphed their move well enough in advance that nearly all analysts saw it coming. What's more, the ECB's cut to 4.75% was only the second easing since 1998, while the BoE's move to 5.25% was the third cut this year.

Business and government leaders criticized the ECB's rate cut as too little too late, but others say it was too much too soon and represents a dangerous caving in to political pressure that could undermine the bank's credibility in the future. Francesco Giavazzi, a research fellow with the Council of Economic Policy Research (CEPR) and one of the more respected ECB watchers, says the cut is in keeping with the ECB's mandate. …

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