The ECB: Sticking to the Playbook?

You migth think that the ECB had a tough enough job trying to find a rate to match the divergent economies of the zone but mind you dear reader Trichet's job is not getting easier as we go along. What we basically have here is question of sticking to the playbook or adjusting to new signals from the surrounding world. The former approach would imply continuing focus on money supply indicators (still) signalling excess liquidity and keeping the idea and transition towards a neutral interest rate in which the economy grows a near capacity without habouring inflation (this would probably imply a nominal rate of about 4.5-5%). Furthermore, this course would enable the ECB to retain the much cherished image as a vigilantee against inflation. However, it seems as if the ECB is finding it extremely difficult to justify this course these days and as such a the latter approach might be called for. So what new signals should the ECB adjust to? Well, grumpy finance ministers notwithstanding the headline inflation rate actually fell below the target rate of 2% last month (1.8%) mainly because of bullish bearish (whoops :)) oil prices. Furthermore a US slowdown and fiscal challenges in key members countries could prohibit the ECB from raising. So what is in store ...

(From the FT linked above - bold parts are my emphasis)

'Thanks to tumbling oil prices, headline inflation, at 1.8 per cent last month, is back within the ECB’s definition of price stability – an inflation rate “below but close” to 2 per cent. On Thursday, Jean-Claude Trichet, ECB president, may point out the volatility of monthly numbers. The bank also fears underlying inflation pressures are gathering – a stronger growing economy could lead to wage growth accelerating – and its latest projections, released in August, show average inflation above 2 per cent next year.

But with interest rates judged to take several years to have an impact on inflation, it is the outlook for 2008 that is crucial, by which point inflation may well be back consistently within the ECB’s target range, depending on oil price moves. The eurozone faces a number of obstacles to further growth – including a possible US-led slowdown in global growth and fiscal tightening in Germany and Italy, as well as the delayed effects of interest rate rises already announced.'

(...)

'At its December meeting, the ECB will have its first published inflation projections for 2008. Along with the other evidence, that might make it an appropriate moment to announce another quarter-point rise in interest rates before leaving them on hold for much of 2007.

That, at least, is the expectation of many ECB-watchers. But Mr Trichet is unlikely to say as much. Although the ECB prides itself on its short-term predictability – signalling rate rises a month ahead – it refuses to “pre-commit” itself to a particular course of action over the longer term.

Mr Trichet believes that by simply signalling its willingness to act at any time, the ECB can shape expectations, obviating the need to actually change interest rates. During the deflation scare earlier this decade, Alan Greenspan, then US Federal Reserve chairman, pledged that interest rates would remain low for “a considerable period”. The ECB made no such a commitment but held rates at 2 per cent for more than two years.

The Fed now talks of a “pause”; the word is unlikely to pass Mr Trichet’s lips, even if the ECB de facto puts further changes on hold.'

(...)

Eurozone interest rates peaked at 4.75 per cent in 2000 but at that time the euro was weaker, and so higher rates were needed to get the same tightening effect that they would today.

The ECB will also watch housing market developments and the eurozone’s credit binge. In spite of signs of an overall slowdown, the ECB will fret about countries such as Ireland, where house prices might even be accelerating again.

But the ECB also argues against deliberately pricking asset bubbles. Were interest rates to rise much further, they might cause significant problems of consumer indebtedness in parts of the eurozone. That may strengthen the case for talking tough, ignoring the politicians – but proceeding with caution'