The European Central Bank remains seriously out of step with other key central banks in the industrial world despite recently announced coordinated efforts to increase short-term liquidity in the banking system. The United States, Canada, and the United Kingdom all have cut interest rates recently. But the ECB holds firm against cutting; indeed, after the Governing Council’s December meeting, ECB President Jean-Claude Trichet said that some members were in favor of raising rates.

Who are they kidding? Everyone knows that the ECB cannot raise interest rates now, and for some time to come. In the midst of the most serious financial crisis in recent memory, the ECB has resorted to an unconvincing bluff, because it has an inflationary expectations problem.

Past policy missteps are responsible for the ECB’s present predicament.

The first misstep was the ECB’s delay in tightening monetary policy, long after it had become obvious that interest rates had been held too low (at 2%) for too long (from June 2003 to December 2005). The ECB’s hawks, understanding the dangers of abnormally low interest rates for a central bank whose primary objective is price stability, had been eager to start raising rates earlier. But the leadership was too timid.

A faster pace for rates hikes could have offset the slow start, but the ECB again erred on the side of caution. For reasons that are unclear, Trichet, in contrast to the ECB’s first president, Wim Duisenberg, has wanted to raise rates by only 25 basis points at a time. Many in the Governing Council wanted to go faster, because they knew they had a long journey in front of them, but Trichet refused.

The hawks were right to be in a hurry. Because of the late start and slow pace, the Governing Council had reached only the 4% mark when the current financial crisis effectively put a lid on further rate hikes. Trichet even had to rescind the rate hike he had signaled for September, though he still claims the increase has been merely postponed, not abandoned.

Not a chance. The truth is that ECB would not be in its current predicament if the central bank had reached the 4.75% or even 5% level by now. Higher rates would have meant lower inflation, so that inflationary expectations would not be the issue they have become. Moreover, from a higher rate level, the ECB would be in a better position to cut rates now that the economy is slowing.

Several frustrated hawks on the Governing Council are dead set against cutting interest rates precisely because they believe that, at 4%, rates already have been “cut” from the 5% or so levels they had expected to achieve. They don’t want to go further, and one can understand their chagrin, if not agree with their policy stance.

The ECB will have to cut interest rates in 2008 if it wants to avoid a hard landing for the euro-zone economy.

Being out of step has consequences. The euro has sharply appreciated, for example, causing Trichet to condemn “brutal” currency moves. When the Canadian dollar sharply appreciated, the Bank of Canada did more than talk – it cut interest rates.

The ECB has the same option, but refuses to use it. Along with its empty threats of interest rate hikes, there is a real danger the ECB will be labeled the central bank that barks but doesn’t bite (animal behaviorists know that barking and biting are substitutes, not complements).

The ECB’s credibility is on the line. How seriously, one wonders, did the Chinese take Trichet when he came to China to protest the euro’s “brutal” appreciation against the renminbi? Cut your own interest rates, they must have thought to themselves, and you will have less to complain about.

Being out of step also focuses attention on the fact that the ECB is in danger of losing control over inflationary expectations. The US Federal Reserve can cut 100 basis points from the federal funds rate and not lose control over US inflationary expectations. Yet, the ECB cannot cut interest rates 1 basis point because it fears euro-zone inflationary expectations are becoming unglued.

This is clear and convincing evidence of the ECB’s previous policy missteps in the normalization of interest rate process. If Europe’s central bank had not been too late and too slow in the past, it would have been truer to its own price stability mandate, and not now out of step with central banks in other industrial countries.