Sebastian Dullien
Next Thursday, the ECB will most likely increase its interest rate by 25 basis points to 4.25 percent. Its president Jean-Claude Trichet has all but pre-announced this move and other members of the governing council have been busy underlining the message over the past weeks. This move could prove to be the most risky move ever done by the ECB - economically as politically.
From an economic point of view, the rationale for this move is rather weak. According to business surveys published last week, the euro-area economy has been close to stagnation in June and is heading for a further slow-down. According to purchasing managers in the manufacturing sector, the sector has contracted for the first time in years. The ifo-index for the German busincess climate marked a sharp drop, with the forward-looking business expectations falling to the lowest level since 2005 - the time just before the country started to recover from its long slump. Business confidence is even worse in Spain, Italy or France. Moreover, in several countries, including Spain, Italy and Ireland, unemployment is now clearly on the rise. Spain and Italy either are already in recession or will slip into recession over the coming months.
All this should be enough to prevent second-round inflationary effects from the oil price shock of the past months. Unions are just not going to push for high wage increases in the wake of a slowing economy and increasing unemployment. Moreover, as core inflation in the euro-area does not show any sign of picking up yet, but inflation stemming exclusively from increased energy prices, the economic wisdom of getting headline inflation down quickly by interest rate hikes is highly questionable.
Adding another interest rate hike in this environment might help the economy reaching the inflation target of "below, but close to 2 percent" slightly earlier than it would otherwise be the case - but only at the expense of a greatly increased risk to economic growth.
This is politically highly dangerous for the ECB. If the ECB moves now in such a visible and controversial way, blame for any accidents that might happen to the euro-economy over the coming months will be put to the ECB. If the euro-area should fall into recession next year, the camp of ECB-bashers will definitely find more supporters. Especially if the US economy starts to recover into 2009 while Europe's economy slows further, a number of people will - with some justification - ask whether the ECB really managed the fallout of the credit crisis well.
Moreover, this move might actually increase the euro-scepticism in countries which are going to experience a recession now anyway. In Ireland and Spain for example, many mortgages are directly linked to LIBOR. With LIBOR actually already performing a jump after Trichet pre-announced the interest rate increase at the last ECB press conference, the Irish and Spanish households will directly feel the pain.
What is worse, these people will know where to put the blame. When I was at a conference in Dublin (see here) and arrived on the day of the last ECB meeting (about ten days before the Irish Lisbon referendum), the taxi driver from the airport was talking about Trichet hinting at an interest rate hike. In Berlin, you would probably not find a single taxi driver who exactly knows what the ECB is doing, much less what its president has said in the last press conference. So, the Irish will directly draw the link from higher mortgage payments to European decision makers in Frankfurt - and possibly to the European integration process as a whole. So long, criticism of the euro and a debate on a possible exit has come mainly from Italy. The ECB is now preparing the ground for similar discussions in other countries.
The ECB board seems to forget that even a legal guarantee for independence in a multinational treaty is only as good as the political support the central bank has in the population. After all, countries can always leave a currency union. Other countries have reneged on constituional guarantees of their exchange rate regimes or multilateral treaties on fixed exchange rates. The most important element of central bank independence is not the legal environment, but the political culture and the people's trust in the central bank. If a central bank gambles away this trust, it will in the long run also lose its independence.
From an economic point of view, the rationale for this move is rather weak. According to business surveys published last week, the euro-area economy has been close to stagnation in June and is heading for a further slow-down. According to purchasing managers in the manufacturing sector, the sector has contracted for the first time in years. The ifo-index for the German busincess climate marked a sharp drop, with the forward-looking business expectations falling to the lowest level since 2005 - the time just before the country started to recover from its long slump. Business confidence is even worse in Spain, Italy or France. Moreover, in several countries, including Spain, Italy and Ireland, unemployment is now clearly on the rise. Spain and Italy either are already in recession or will slip into recession over the coming months.
All this should be enough to prevent second-round inflationary effects from the oil price shock of the past months. Unions are just not going to push for high wage increases in the wake of a slowing economy and increasing unemployment. Moreover, as core inflation in the euro-area does not show any sign of picking up yet, but inflation stemming exclusively from increased energy prices, the economic wisdom of getting headline inflation down quickly by interest rate hikes is highly questionable.
Adding another interest rate hike in this environment might help the economy reaching the inflation target of "below, but close to 2 percent" slightly earlier than it would otherwise be the case - but only at the expense of a greatly increased risk to economic growth.
This is politically highly dangerous for the ECB. If the ECB moves now in such a visible and controversial way, blame for any accidents that might happen to the euro-economy over the coming months will be put to the ECB. If the euro-area should fall into recession next year, the camp of ECB-bashers will definitely find more supporters. Especially if the US economy starts to recover into 2009 while Europe's economy slows further, a number of people will - with some justification - ask whether the ECB really managed the fallout of the credit crisis well.
Moreover, this move might actually increase the euro-scepticism in countries which are going to experience a recession now anyway. In Ireland and Spain for example, many mortgages are directly linked to LIBOR. With LIBOR actually already performing a jump after Trichet pre-announced the interest rate increase at the last ECB press conference, the Irish and Spanish households will directly feel the pain.
What is worse, these people will know where to put the blame. When I was at a conference in Dublin (see here) and arrived on the day of the last ECB meeting (about ten days before the Irish Lisbon referendum), the taxi driver from the airport was talking about Trichet hinting at an interest rate hike. In Berlin, you would probably not find a single taxi driver who exactly knows what the ECB is doing, much less what its president has said in the last press conference. So, the Irish will directly draw the link from higher mortgage payments to European decision makers in Frankfurt - and possibly to the European integration process as a whole. So long, criticism of the euro and a debate on a possible exit has come mainly from Italy. The ECB is now preparing the ground for similar discussions in other countries.
The ECB board seems to forget that even a legal guarantee for independence in a multinational treaty is only as good as the political support the central bank has in the population. After all, countries can always leave a currency union. Other countries have reneged on constituional guarantees of their exchange rate regimes or multilateral treaties on fixed exchange rates. The most important element of central bank independence is not the legal environment, but the political culture and the people's trust in the central bank. If a central bank gambles away this trust, it will in the long run also lose its independence.
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