ECB set for an error for the ages

March 29, 2011

In a field of endeavor with a long and glorious history of folly, the European Central Bank is preparing to commit an error for the ages: hike interest rates into the face of a crisis of existence for the euro zone.

There is an increasing likelihood that when the ECB meets  on April 7 they will respond to surging energy costs and 2.4 percent annual inflation – the highest since 2008 – by raising interest rates, probably by a quarter of a percent.

“Inflation rates … are now durably above the common definition of price stability in the euro zone,” ECB President Jean-Claude Trichet told an audience in Paris on Monday.

This reinforced expectations of a hike he introduced in early March when he dropped the words “strong vigilance” into remarks following the last interest rate-setting meeting, a phrase that served as a one month warning of rate hikes to come during the 2005-2007 rate hike campaign.

Reports that the ECB is preparing a new bail-out lending vehicle for Irish banks, taken as a precursor to a wider effort at bank relief, are being read in markets as further evidence that the ECB is ready to tighten. The reasoning is that, having squared away the banks, and their mutually dependent sovereign guarantors, nothing will stand in the way of an old fashioned bout of inflation scourging.

Here we see the ECB’s conception of itself – as an institution proudly above the political fray and dedicated single-mindedly to price stability – clouding its ability to treat with reality.

“Sure”, you can almost hear ECB types say to themselves, “we’ve accepted some pretty horrendous collateral, and sure, we’ve kept insolvent banks alive through providing massive liquidity, but at heart we are just honest inflation hating bankers, just like our forebears at the Bundesbank.”

Actually though, as Bank of England Monetary Policy Committee member Adam Posen points out, the Bundesbank, when confronted with the oil shock and global recession of 1979-80 dealt with energy-driven inflation quite differently.

“The Bundesbank made public that it would take several years to bring inflation back to its target long-run inflation level, even though it would partially offset the shock immediately and inflation would rise. In fact, it took six years for German inflation to be brought back to 2.0 percent, and both the Deutsche Mark and the Bundesbank retained their counter-inflationary credibility,” Posen said in a February speech.

Now, when you recall that the Bundesbank was slightly to the right of Atilla the Hun in its attitude towards inflation, the ECB’s current course of action looks even more, to be polite, remarkable.


Remarkable, especially, when you consider what is being asked of the peripheral euro zone countries. Greece, for example, last year tightened fiscal policy by 8.0 percent of GDP, a statistic that is more impressive before you learn that its economy, partly as a result, shrank by 5.0 percent. You really cannot do that too many years in a row, either mathematically, or politically.

A semi-revolt against austerity measures in Portugal prompted the resignation of Prime Minister Jose Socrates last week, leaving a European rescue plan in limbo. Portugal is now being pressured to accept a bailout, but there is real doubt as to whether it will sign on for the measures expected, and even more doubt as to whether it can stick with them over time.

Inflation is not the problem in Portugal, it is declining standards of living, exacerbated by rising energy costs, but really the result of a squeeze on labor and consumption that is its only means of regaining competitiveness as it has no currency of its own to devalue.

Or take Ireland, which is fighting for better bailout terms, its latest gambit being to push the idea of burden sharing for bank creditors to its crippled banking system. As burden sharing means banking crisis, you can take this as a negotiating position. Or consider Spain, whose own banking system and economy will not be helped by the ECB fighting inflation.

Meanwhile there is a lack of convincing evidence even in the stronger countries of the euro zone that inflation is hardening into large wage rises.

In the meantime, there is evidence that the European recovery, uneven as it is, is facing headwinds. Measured in real terms, currency in circulation and overnight bank deposits in the euro zone are contracting, a strong leading indicator of a slowdown. While this trend started in the weak periphery, it has spread to the core, and is troubling.

A rate hike will rain down even more pain on struggling Spain and its peers and will on the margins make their task of outgrowing their debts and honoring their European commitments even less feasible and will do exactly nothing about the real cause of inflation – rising energy prices.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)


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As the dominos are falling in the middle east it will be crucial to maintain oil supplies or else the energy shock resulting will stall the economic recovery. Should that be allowed to happen it will be deflation and inflation at the same time which will be very unpleasant indeed. Get some energy stability first then worry about policy.

Posted by Har | Report as abusive

The ideal policy is to have stable currency — not steady inflation, which robs creditors to encourage and reward debtors. The US and many other nations have adopted policies of consistent inflation (robbery) — a corruption which has been the downfall of governments from the beginning of recorded economic history.

Like the Ponzi scheme, it promises ever-growing incomes — but in fact brings about ever growing poverty.

Giving inflation up is like giving up any addiction — the pain of withdrawal always seems too much to bear. Doing it in a crisis is tough, but doing it when we are all flying high is tougher.

Posted by fredricwilliams | Report as abusive

Why then do the majority of the economists at the Bank of England think ( in the face of much higher inflation than Europe )that the UK should endlessly postpone a rate increase? Only Germany is growing strongly and a rate increase in the Eurozone would appear to be the last thing that many member countries need. So who is right – the ECB or the B of E?

Posted by pavlaki | Report as abusive

[…] into the core of the EU as well. March 30th, 2011 James Saft believes the ECB is about to make an epic mistake, hiking rates to counter inflation readings that are high only because of rising energy costs. […]

Posted by James Saft believes the ECB is about to make an epic mistake, hiking rates to counter inflation readings that are high only because of rising energy costs. It’s not just the periphery that will suffer, he claims, but leading signs of a slowdown are | Report as abusive

Trichet should not be focusing on inflation – a 0.25% rate hike will only make things harder for the PIIGS. Anthony Harrington cites Jim Saft in his recent blog: rrington/2011/04/04/the-ecb-on-the-brink -of-another-historic-blunder-ecb-rate

Posted by QFinance | Report as abusive

[…] alluded to the Bundesbank’s previous ‘oil shock’ action. As he noted in a speech in February 2011: The Bundesbank made public that it would take several years to bring inflation back to its target […]

Posted by FT Alphaville » A call for central bank action on commodity prices | Report as abusive

[…] that´s not how it went down in Germany. As this post mentions, Adam Posen, a former colleague of Sentance at the BoE said about that episode: The […]

Posted by Andrew Sentance is the “Joseph Kony” of Monetary Policy | Historinhas | Report as abusive