The case for a rise in European interest rates

By: Wolfgang Munchau

What I am about to say will be unfashionable. I think the European Central Bank should raise interest rates from the current level of 4 per cent, and that it should not wait until next year. This is not a prediction of what will happen. On the contrary, I expect it will not happen.

The biggest single factor that determines any central bank’s overall monetary stance is the inflation target. The ECB has an inflation target of “close to but less than 2 per cent”. If one accepts the inflation target as a given, any disagreement is necessarily technical, not ideological.

Of course, different forecasters may place different weights on certain kinds of information. But over time one would expect rational views to converge.

That is not the case if the disagreement is about the target itself. Then anybody can say anything.

The case for a rise in interest rates, on the basis of the inflation target, derives from the following considerations. Actual inflation, at 2.6 per cent in October, is clearly above target. Forecasts suggest that inflation will remain at elevated levels until the end of the year.

Next year, inflation is forecast to stay at more than 2 per cent as well. I am agnostic about oil and food prices. They may be a source of inflation, or disinflation, in 2008.

The biggest upside risk to any inflation forecast is the labour market, which has begun to tighten during the most recent economic recovery. An indication of rising wage pressures, clearly the most important source of inflationary pressures, was the recent 4 per cent wage deal in the Austrian engineering industry, considered a benchmark for the country.

Of course, Austria is small but its labour market is comparable to Germany’s, where wage pressures are also rising. While a 4 per cent earnings rise is not extreme, certainly not by the standards of Anglo-Saxon countries, it nevertheless marks a shift from a disinflationary to a neutral trend.

A symbolic example of the end of wage moderation in Germany has been the ongoing train drivers’ strike in support of a 30 per cent pay rise. The German labour market has had a substantial disinflationary impact on eurozone inflation in recent years. This is about to end.

Monetary and credit developments also point towards a relatively tight position. The annual growth in M3 money supply – a broad measure – averaged 11.5 per cent between July and September. Loans to the private sector rose by 11.1 per cent. In September, the annual growth rate of loans to non-financial corporations was 14.1 per cent higher than a year ago.

While inflation is elevated, economic growth is forecast to remain above, or close to, potential growth. For example, the International Monetary Fund, in its latest World Economic Outlook, forecasts an economic growth rate for the eurozone of 2.5 per cent for 2007, and of 2.1 per cent in 2008.

All these events, trends and forecasts suggest that inflation is not merely above target but that inflationary pressures are, at the very least, not easing, and quite possibly increasing. In such a situation one would tend to expect short-term interest rates to be somewhat above a neutral level.

Now, of course, the notion of a neutral interest rate is controversial. If it exists, it would be reasonable to expect that it might change over time. A very rough back-of-the-envelope calculation suggests that the present short-term rate of 4 per cent must be close to a neutral level.

The eurozone has potential growth of about 2 per cent, and an inflation target at about 2 per cent. Add them together, you get to 4 per cent. There are more sophisticated ways to estimate it, but most estimates I have seen point towards a neutral rate of close to 4 per cent, plus or minus half a percentage point.

In the monetary policy discussions, three specific arguments have been used against a rise in interest rates at this stage.

The first is the uncertainty caused by the credit market turmoil. It would be better to wait until the fog clears. But then, it always is. While the credit squeeze is a serious financial market event, it should not serve as an excuse to put monetary policy on hold forever. Making judgments under uncertain conditions is what central bankers are paid for.

Secondly, the rise in money market rates may have obviated the need for a rate rise by the central bank.

The problem with this argument is that a central bank’s announced interest rate has important signalling functions that would get lost if financial markets were to take the lead.

The third frequently heard argument is the rise of the euro’s bilateral exchange rate against the dollar. But the exchange rate that matters for monetary policy purposes is the real effective exchange rate.

The index of the euro’s real effective exchange rate against a narrow group of currencies stood at 108 at end-December 2004, falling to 102 a year later, and reached 108.9 in mid-September this year. This is hardly dramatic.

The right course of action would therefore be to raise interest rates now.

The ECB will probably not do so because it wants to avoid a political clash with politicians who are calling for rate cuts. But in that case, it risks a persistent rise in inflationary expectations.

munchau(at)eurointelligence.com

Copyright The Financial Times Limited 2007

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