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Don’t Follow The Fed

The US Federal Reserve faces a dilemma, for it needs to continue raising interest rates in the face of a hurricane-devastated economy. The Fed’s failure to raise rates earlier thus holds a powerful lesson for the European Central Bank: after a prolonged period of monetary stability at unusually low interest rates, waiting too long to raise rates to more normal and appropriate levels holds dangerous consequences.

The Fed was late in beginning the interest-rate normalization process, and it is now paying a price. The ECB must not make the same mistake, even bearing in mind that the two central banks operate in different milieus and under different constraints.

Warning signs of impending inflation abound across the euro zone. Money-supply growth has been well above target levels for some time now, indicating excess liquidity. September headline inflation, at 2.6%, is above the ECB’s 2% target ­– as is the latest forecast for 2006 inflation (updated forecasts will be released at the beginning of December). “The period of wage moderation may be coming to an end,” warns Otmar Issing, the ECB’s chief economist, implying that soaring energy prices may now be feeding through into the overall price level (so-called “second-round effects”).

In these circumstances, there is no good reason to wait to raise interest rates. The longer energy prices remain at their current lofty levels, the greater the probability that inflationary expectations will increase and that second-round effects will materialize. Further procrastination on interest-rate normalization by the ECB could well lead to a nasty bout of inflation. This would be disastrous for Europe’s economic recovery, as the ECB would have no choice but to slam down hard on the monetary brakes.