ECB's wait-and-see policy and the case for higher interest rates

Thursday 05 June 2008

The European Central Bank on Thursday left its benchmark interest rate unchanged. But with the threat of a global economic downturn, the ECB finds itself caught in something of a Catch-22.

As expected, the European Central Bank on Thursday left its benchmark interest rate unchanged at 4 percent.

 

During a press conference that followed the bank’s monthly meeting, ECB President Jean-Claude Trichet hinted at a rate hike next month. By doing so, he sent a clear signal that European policymakers seem more worried about rising inflation than they are about waning growth prospects.

 

As a matter of fact, rising food and energy prices have propelled inflation to its highest rate in 16 years, 3.6 percent in May. The bank also raised its inflation forecast for this year and next, to 3.4 percent in 2008 and 2.4 percent in 2009. That’s well above a European inflation ceiling of just 2 percent, a level the ECB has had difficulty meeting ever since its creation 10 years ago.

 

Inflation has become a key concern in Asia as well: central banks in Indonesia and the Philippines raised interest rates today, the same day the ECB decided to keep its own rates on hold.

 

Raising interest rates is seen as a way to combat price increases. By strengthening the euro – which gained one cent against the dollar on Trichet’s comments, rising to $1.55 - it should help cushion the impact of expensive oil and reduce the energy bill for both households and companies.

 

But with fears of a recession in the United States, and the threat of an economic downturn hanging over the world's economy, the ECB finds itself caught in something of a Catch-22. High interest rates tend to deter companies from investing, and to encourage households to save money instead of borrowing to finance their spending. This generally leads to slower growth. But the ECB doesn’t seem concerned by the risk of a recession. It predicts a growth forecast of 1.8 percent for the eurozone, which remains close to its previous estimate.

 

The worst impact will probably be felt by European companies exporting in dollars or dollar-pegged currencies. Since September, the US Federal Reserve has cut its interest rates seven times while the ECB has kept its own benchmark rate on hold. The widening rate differential on both sides of the Atlantic has led the euro to surge 15 percent against the dollar. That’s a 20-cent increase. And it’s bad for a company like Airbus. Its chief executive Louis Gallois recently reminded analysts that a 10-cent rise in the euro against the dollar costs the company 1 billion euros.