The current dilemma of the US Federal Reserve of having to continue raising interest rates despite the hurricane-wounded US economy holds a powerful message for the European Central Bank.
After a prolonged period of monetary stability at unusually low interest rates, there are dangerous consequences of waiting too long to raise rates to more normal and appropriate levels. The Federal Reserve, having taken interest rates down to spectacularly low levels—in part, because of misplaced fears about deflation-- started the interest rate normalization process too late. Now it must continue to raise rates even though there are signs --like declining US consumer confidence — that America’s economy may be faltering. The ECB must not make the same mistake.
Warning signs of impending inflation abound in the euro-zone economy. Money supply growth has been well above target levels for some time now, indicating a condition of excess liquidity. October headline inflation at 2.5% is above the 2% ECB target -- as is the latest forecast for 2006 inflation (updated forecasts come out the first of December). Soaring energy prices threaten to work their way into the general inflation process.
Why wait? Further procrastination on interest rate normalization by the ECB could well lead to a nasty bout of inflation. This would be disastrous, in particular, for Europe’s economic recovery. The ECB, in such circumstances, would have no choice but to slam the monetary brakes down hard.