Should 3.5% be the end of the story?

By: Manfred J.M. Neumann

 
The ECB has acted as expected, increasing its key interest rates by another 25 basis points at the meeting of 7 December. Within a year’s time the main refinancing rate has been driven up from 2 to 3.5 %. Long-term rates have followed the rise though by much less. As a result the yield curve has become almost flat meanwhile. This suggests that markets currently do not expect a significant and lasting further tightening of monetary policy for 2007. It fits that in his introductory statement president Trichet has softened his interpretation of the policy stance in a subtle way. He neither mentions the “strong vigilance” anymore nor that it “remains warranted to further withdraw monetary accommodation”. At the same time, he concedes that “the outlook for price developments remains subject to upside risks” and that “monetary policy continues to be accommodative”. Thus, while the door remains open for further increases of the key rates, the Governing Council appears to be undecided whether and when to act.

 

Given what we know about the current stance of monetary policy, it is hardly defendable to take a patient wait-and-see attitude. In evaluating the policy stance it is necessary to take a long-run view and to analyse the trends in money creation and interest rates. Money is the long-run anchor of asset and consumer prices. As a rule of thumb the trend growth of money should equal the ECB’s normative rate of inflation (2 %) plus the product of the income elasticity of money demand (1.5) and the trend rate of real income growth (1994-2006: 2 %). The formula provides an inflation-neutral growth rate for the money stock M3 of 5 %. This yardstick implies that monetary policy is much too accommodative since spring 2001; see the money chart. No surprise that the ECB has not succeeded in keeping inflation at the desired level of close to but below 2 % during recent years. Since the turn of the century consumer price inflation has moved around an average level of 2.2 % even though the economy has grown at a moderate annual rate of 1.8 % on average. Moreover, money and credit are accelerating. Since early 2005 M3 is rising at a rate of 8.5 %. The money overhang exceeds 14 % meanwhile. Indeed, by all money measures liquidity is ample, thanks to a generally too timid conduct of interest rate policy.

 

Too fast money growth indicates that the ECB’s supply price of money, represented by the interest rate on overnight money, is too low. Theory suggests that the real overnight rate, i.e. the overnight rate deflated by the rate of inflation, must not undercut the economy’s trend rate of growth (2%) to secure price stability in the long run. But fact is that the real overnight rate has moved widely below this number since mid-2001; see the interest rate chart. This long-lasting policy of cheap money is at the heart of the explanation of the observed excessive money growth. Though the most recent decision of the ECB brings some correction, it is by no means sufficient. Deflating the nominal supply price of 3.5 % by the ECB’s inflation objective yields a real supply price of 1.5 % instead of 2 %. Thus, it would require lifting the ECB’s nominal supply price by another 50 basis points, hence to 4 %, in order to achieve a level that is compatible with price stability in long-run equilibrium.

 

Note that this is not the complete story because the economy is not growing alongside an equilibrium path of normal growth and price stability but stronger. If this continues, it will become necessary to target a non-accomodative interest rate level of 4.25 %. The consensus GDP forecast is 2.7 % for this year and 2.2 % for next year. The odds are that the forecasters are repeating the error of last year when they greatly underestimated the strength of the economy. In addition, it appears overly optimistic to assume that average inflation will fall below this year’s level of 2.2 %, the more so, the longer the ECB hesitates to further drive up its supply price.

 

The accommodative policy stance needs to come to an end, the sooner, the better. The members of the Governing council should know that even though they do not advertise it. The oncoming meeting of 11 January provides an opportunity for further correction that must not be missed.

 

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