Two things stand out from the European Central
Bank's decision effectively to pre-announce a rise in interest rates
next month. First is its eagerness to polish up its inflation-fighting
credentials after being slurred by Axel Weber
and much of the German press and political elite; second is its
confidence in the ability of its "non-standard" measures to stop a
breakdown of the financial system.
Both may be justified, but the bank's motives may not be of the purest.
Associated Press
German Central Bank Governor Axel Weber in Paris last month.
The
ECB's credibility has been under intense scrutiny in Germany as a
result of its response to the crisis. That scrutiny has become even more
intense since the decision by Mr. Weber effectively to pull out of the
contest to find a successor to Jean-Claude Trichet
rather than run for the presidency of an institution that he considered
too soft on inflation and too soft on profligate governments.
Mr. Weber's planned departure from the Bundesbank next month has put
more pressure on the ECB to be hawkish than they would otherwise have
been yesterday, both directly and indirectly.
Directly, because of the political imperative in Germany to respond
to Mr. Weber's rebuke. Indirectly, because Mr. Weber was the most likely
candidate to succeed Mr. Trichet when his contract expires in October.
Now the Mario Draghis, Nout Wellinks and Yves Mersches of this world are
engaged in a hawkier-than-thou war of words, transparently trying to
persuade German Chancellor Angela Merkel that each is the man to defend
the German cult(ure) of stability at the top of the ECB now that their
own candidate has withdrawn.
That on its own would be no particularly convincing reason to raise
interest rates now. Another reason not to do so would be the evidence of
its own monetary analysis, on which it claims to put so much emphasis.
The last time the ECB began raising interest rates—in December 2005—
private-sector credit was growing at 9% a year. In the three months to
January 2011, it grew at an annualized 2.1%. Corporate borrowing in
particular is still doing little more than flatlining, and household
borrowing levels are also well below their historical levels.
In short, for all its sophisticated rhetoric about expectations of
inflation rates in the medium term, the ECB has taken an unabashedly
knee-jerk decision. Inflation has been above its tolerance threshold of
2% for all of two months, and the central bank is already talking about
its first interest rate increase since the collapse of Lehman Brothers
Inc. And all because of factors that are completely beyond the control
of governments and the "social partners" of management and labor that
really drive euro-zone wage policy.
As such, the ECB is acting tough to defend its credibility, but its
action is not consistent with much of its traditional message.
If that were all there was to it, it would be hard to avoid damning
them for a bunch of posturing pseudo-hawks. Thankfully, that isn't the
case. A close look at the ECB's announcements Thursday shows that it
isn't preparing to throw the euro-zone's highly-indebted periphery to
the dogs in defense of a facile definition of credibility.
Ever since spring 2009, the economy has been floated back to growth
on a tide of central bank liquidity and the ECB has balanced price
stability against financial stability, hoping that it wouldn't have to
raise interest rates before the euro zone could clear up its banking
system.
As it became clear that the problems of the banks would take years
rather than months to solve, the ECB has had to devote more attention to
making sure that no major European bank collapsed, triggering a re-run
of the post-Lehman mayhem in 2008.
It has done this with a range of non-standard measures, the most
effective (and enduring) of which have been a policy of unlimited
lending to banks that can post eligible collateral, and a big relaxation
of the definition of eligible collateral itself— effectively lending
hard cash against junk paper.
Mr. Trichet has always claimed the standard and the non-standard
measures can be operated independently. He has never had to prove this
until now.
If, as seems likely, the ECB raises its refinancing rate next month,
it will continue to lend unlimited amounts to banks that have no
recourse to private financial markets. The big gamble is that market
rates in the core countries can edge higher without tipping the
periphery into bankruptcy.
That rests on the assumption that simple availability of ECB
liquidity is more important to addict banks than the 25 basis points
extra on the cost.
For that gamble to pay off, the ECB may have to deploy its other
principal non-standard weapon— the purchase of government bonds.
Higher central bank rates will almost certainly bring higher
government borrowing costs. For Spain and Portugal in particular, still
trying to finance themselves through the market, any rise in interest
rates will be hard to stomach. In falling bond markets, yield spreads
usually widen, and Portugal will almost certainly need heavy buying from
the ECB to keep its 10-year yields below the 7% level that its
government thinks is sustainable.
You can argue that such a scenario would amount to the de facto suspension of a single monetary policy for the euro zone.
There would be, more clearly than ever, one policy for the periphery
and one policy for the core, irrespective of the actual level of
interest rates, and it would create obvious political difficulties in
the present climate.
But if you have been arguing that the ECB needs to make at least a
tactical retreat from the rigors of one-size-fits-all, then its action
is overdue and ycould hardly blame it for doing so.
Write to Geoffrey T. Smith at geoffrey.smith@dowjones.com
| 
