Wednesday, September 17, 2014

The ECB’s Honeymoon is Over

The honeymoon for the European Central Bank is over. Because European interest rates no longer are clearly out of whack with the fundamentals of the euro-zone economy, monetary policy has become more complex.

At the same time, France has given a strong mandate to its new president, Nicolas Sarkozy, who is without question the most formidable political adversary the ECB has had to face in its brief history. Sarkozy stands ready to pounce on any mistakes the Bank may make in this more difficult policy environment.

With European interest rates up 200 basis points since late 2005 and the euro near a record high, Sarkozy wants the ECB to stop raising rates now. ECB president Jean-Claude Trichet and the Governing Council strongly disagree.

At the ECB press conference in early July, Trichet signaled at least one more rate hike—either in September or October. Some Council members are known to support two more rate hikes before year-end.

What makes monetary policy tricky at this point is that the German economy—which has been Europe’s locomotive during the current cyclical upturn—may be reaching a turning point. Surveys of business and investor confidence have softened—the respected IFO index of German business sentiment fell from 107.0 to 106.4 in Julyamp#45;amp#45;and the so-called “hard data”—industrial production, retail sales, etc.amp#45;amp#45;- has been mixed. Second quarter German GDP has stalled after a surprisingly strong first quarter.

The jury is out but there is reason to be concerned. The euro is at record levels, oil prices are surging and interest rates are expected to go higher. The euro-zone economy—including Germany’samp#45;amp#45;is not bulletproof though the hawks in the Governing Council often talk as if it were.

Just as last year when there was unwarranted growth pessimism in Europe, this year there is unwarranted growth euphoria. Many Germans, in particular, are in denial that the cyclical upturn may be coming to an end.

Were the Governing Council to miss the coming turn in the European economy while blithely raising interest rates, they would be portrayed as drunken sailors on a rate-raising binge. The roar for greater political control over Europe’s central bank would be deafening—and not only from France.

The political costs for the ECB of making this type of mistake could be exorbitant. This is why the ECB must be very prudent as it considers whether to maintain the current pace of rate hikes, in which case it would raise rates by 25 basis points in September, or slow the pace down a bit, in which case the next rate hike would come in October at the earliest.

In the current political environment, the dangers to the ECB from outside political interference are much greater from raising rates too fast than too slowly. If it goes too slow, the ECB has earned sufficient credibility as an inflation fighter to make up for it in the future with little if any economic or political cost. But if it goes too fast, the political cost could be substantial and irreversible. Politicians will push for more control and probably get it, Maastricht treaty or no Maastricht treaty.

Waiting until October for the next move up is like buying insurance against a catastrophic loss.

But will the ECB see it this way? As a matter of principle, the hawks refuse to consider the political costs of their actions. In earlier times with no formidable adversaries in the political arena, this was a harmless affectation. But it is an extremely dangerous attitude with people like Sarkozy ready, willing and able to impose high political costs upon the bank should it stumble.

There is more interest in Sarkozy’s populist ideas about currency intervention and adding a new political dimension to monetary policy decisions than is commonly realized.

The hawks also suffer from what can be called a “catch up” complex. No matter how high rates go, they think they’re behind. They want to go in September so that they can go again in December (even before knowing the data)—and they won’t stop there either.

Even the doves might support a rate hike in September to counter-act the charge that they are being bullied out of a September hike by Sarkozy. There is no doubt that Sarkozy’s attacks on the ECB are having a counter-productive effect in this regard. They are pressuring the ECB to raise rates sooner than later.

But a September rate move also serves Sarkozy’s interests, as it will give him more ammunition to portray the ECB as out of control and in need of political disciplining. For the ECB to protect itself from such charges, far better to wait until October when the bank can go to the public and say in effect; “Look, do you see how reasonable we have been. Now we must raise rates.”

In the final analysis, whether the next rate increase comes in September, October or whenever—and it looks like September notwithstanding current warning signs like IFO that suggest a possible slowdown in the coming monthsamp#45;amp#45; the data will determine how far the ECB goes with its rate hikes if the bank is savvy enough to keep the politicians at bay. But this is a big “if”.

The fight is on between the two French titans—Trichet and Sarkozy—with the fate of Europe’s central bank hanging in the balance.

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