Forget about Q2

It is sometimes a good idea not to follow each loop in this debate. At Eurointelligence, we were sceptical last spring of forecasts that the ECB would raise rates to 4.5%, or even higher. Now we are sceptical that they would cut interest rates from the present level. The ECB has no such thing as a bias - which is a good thing too. If a central bank knows that it wants to cut or  raise interest rates in the future, it might as well do so now. But judging from the comments by Jean-Claude Trichet, and the actual facts, it is fair to say that if the ECB had any bias, it would be a tightening bias, the euro's exchange notwithstanding.

 

Most critics of the ECB and most analysts tend to forecast the ECB policy response function purely on the basis of the business cycle. It was as though the ECB objective function would be to smooth out the cycle, subject to some inflation constraint. Indeed, if you look back at the euro's short nine-year history, it was quite possible to describe policy in such a way. But it is not a good forward looking indicator, in the sense that it grossly underestimates the increased importance of second pillar - the monetary analysis - and the sheer fact that inflation and the business cycle are no longer perfectly anti-symmetrical. In terms of power play, one should also not totally underestimate the increasing hardline position taken by the two Germans on the ECB's governing councils. This is not the same world any more as that of 2000.

 

If the ECB were a pure inflation targeter, it would have raised interest rates last autumn. The ECB is what one might call a moderate inflation targeter. Trichet is probably right when he says that the ECB's compass is inflation. Obviously, this is the time in which central banks have the opportunity to make a choice. The Fed has clearly made the choice to ignore inflation. The ECB will probably not want to follow down that road. It would produce a near-existential crisis for the future of the euro if any one member state would claim that the euro has become an inflationary currency due to overly lax monetary policies.

 

The upward revision of its inflation forecast is a clear sign that European interest rates have been too low for too long. Last year's decision not to raise interest rates beyond 4% was clearly a mistake, and this has now become increasingly evident as well. This playing into the hands of the hawks, who say that monetary analysis must play a more powerful role in addition to the traditional New Keynesian analysis, which has persistently underestimated the degree of inflationary pressures. Another way to think about this is in terms of two pillars. Forget the rhetoric. Until 2005, the ECB smoothed the cycle. Since then, the monetary pillar has become increasingly important.

 

Also we should not forget that at nominal rates of 4%, euro area real interest rates are hardly positive. A nominal rate of 4% is a lose policy stance. It would have to get quite bad - in terms of inflation like to fall below its 2% target - to find a justification of further rate cuts.  But I would not bet on any credible forecast telling us that inflation is indeed about to undershoot the ECB's target. In other words, the idea that the ECB is going to cut in Q2 is absurd.

 

 

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