June 03, 2002

European Monetary Policy

The Economist reports that "...there is a real risk that the European Central Bank will feel it has to raise interest rates" this summer, and blames it on two factors: (i) the European Central Bank's statutory obligation to keep inflation below two percent per year, and (ii) the failure of European governments to undertake steps that would reduce the unemployment rate at which inflation begins to creep upward. Even so, I find it hard to see raising interest rates today as anything but unwise.

The Economist would prefer--no surprise--to attribute blame to "structural rigidity" instead of (or in addition to) a central bank that doesn't seem to understand its mission. In the Economist's view, it is " governments resistant to the reforms which they have pledged to make" that are at fault: "Europe's labour and capital markets remain much more regulated than those in America: and European economies are now paying the price for that."

European interest rates have fallen by less than American ones since the recession began

Yet, even so--even given the slowness of European governments to undertake structural reforms to reduce the NAIRU, and even given the European Central Bank's statutory obligation to price stability, policy is strange. It is remarkable that the European Central Bank has cut interest rates by only 1.5 percentage points since the end of 2000. Without inflation clearly climbing above two percent, it is hard to justify raising interest rates as a strike--preemptive or otherwise--against inflation. And until there come to be signs of rising wages and shortages of skilled workers, it is hard to see how unfixed "structural rigidities" would enter the European Central Bank's decision-making process.

Besides, there are at least some economists--Olivier Blanchard for one--who seem to think that structural reform has already been accomplished, has not yet paid its NAIRU-reducing dividend, yet is about to...

...But on the substance of policy, the bank’s predicament is real. Again unlike its American and British counterparts, its statutory obligations relate only to the maintenance of price stability. It has no direct role in fostering economic growth (though economists would generally argue that low inflation is a necessary precondition for sustainable growth). Some economists argue that the bank made a rod for its own back in the way it chose to define price stability. America's Fed has no publicly announced target. The British government gives the Bank of England a target which is symmetrical—2.5% plus or minus 1%. This means equal weight is given to fluctuations either side of the central target.

The ECB went for an asymmetric target. Success in achieving its objective means it must bring inflation in at no more than 2%. It has given itself no flexibility to cope with occasions when economic weakness might justify a lower level of interest rates than is compatible with meeting the inflation target. This opened the ECB to considerable criticism last year, when the Fed was slashing interest rates at monthly intervals to stave off recession and the ECB was stubbornly resisting a similarly aggressive monetary policy.

The ECB’s critics might now argue that Europe is paying the price for this. Far from being immune to the global downturn (as some European leaders publicly argued at the beginning of 2001), the euro area has shown it is at least as vulnerable as anywhere else. It is also struggling to recover economic momentum—especially when compared with its transatlantic partner.

Posted by DeLong at June 3, 2002 02:02 PM | TrackBack

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