The ECB Picks Up The Pace

Buoyant US economic growth, so far, has provided the European Central Bank with the necessary global backdrop to raise interest rates from very low levels at a slow and steady pace that limits political friction with euro-zone political leaders but that gets the job done.

That is about to change. The latest anecdotal evidence from the US indicates that the economy is taking a sharp downward turn, which should become manifest in the coming months. Unless the ECB picks up the pace of interest-rate increases now, the goal of interest-rate neutrality may not be politically feasible, jeopardizing achievement of the bank’s price stability goals.

The ECB should act with greater alacrity not because there are increased prospects for future growth, but for the opposite reason: the fear that European growth will slow, thus limiting the possibility for future rate hikes. Indeed, even before the sudden downturn in the US economy, a growing number of members of the ECB’s Governing Council already had come to the conclusion that accelerating the pace of interest-rate increases was needed if its goal of monetary neutrality was to be achieved.

The key reason is that several recent “reforms” announced by German Chancellor Angela Merkel – raising the value-added tax, increasing user charges for healthcare, and taxing interest payments as a part of so-called corporate tax reform – promise to reduce German economic growth, perhaps significantly, in 2007.