Between March and November of 2002, as expectations of European growth in 2003 fell from 3 percent per year to 1.5 percent per year, the ECB stood by and did nothing. Only this month did it bestir itself to cut interest rates by fifty basis points--half a percentage point.
Here the Economist tries to figure out why the ECB seems to be doing so badly as a policy-setting institution. They seem to blame the ECB's institutional setup, but it is not quite clear how, exactly, it is to blame.
Economist.com: ...But why did the ECB leave rates unchanged for so long? By contrast, the Federal Reserve—despite America's higher growth rate—has been willing to cut on several occasions. This year, the euro area has seen one disappointment after another, most obviously in Germany, its biggest member. For instance, unemployment there rose by more than expected in November. In the third quarter, as in the second, GDP in the whole euro area grew by only 0.3%—or 1.2% at an annual rate. The future looks no cheerier. On average, the panel of economists polled monthly by The Economist now predicts growth of a mere 1.5% in 2003. Six months ago, our forecasters expected 2.9% (see chart).
Fiscal policy is doing little to support economic activity. The euro area's stability and growth pact requires members to keep their budget deficits to below 3% of GDP. A breach necessitates swift remedial action—or the offender may risk paying a hefty fine. The French government, it is true, seems to be defying the pact. No wonder, given that French growth slowed to a 0.8% crawl (at an annual rate) in the third quarter. France wants to cut taxes, even though the European Commission, which monitors countries' compliance, thinks it may break fiscal limits in 2003. But in Germany, where a deficit of 3.8% is likely this year, the government is raising taxes, to the fury of businesses and many voters.
The ECB's line has been unsympathetic—not only holding rates, but repeating in schoolmasterly tones the importance of sticking to the rules. The commission recently proposed adjustments to the pact: but the 3% limit would stay, and countries with structural deficits, such as Germany, would still be expected to tighten policy, even in bad times.
One reason for the ECB's slowness, thinks Mark Wall of Deutsche Bank, is institutional. Unlike the Bank of England, it takes no votes (or has so far admitted to none); nor does Mr Duisenberg dominate the governing council as Alan Greenspan does the Federal Reserve's open-markets committee. Consensus is the rule—and a consensus for change can take time to build. Second, and perhaps more important, the ECB's treaty-prescribed duty is not to keep the economy at full steam but to maintain price stability, which it defines as a rate of inflation of no more than 2%. Despite the weakness of the euro-area economy and talk of the risk of deflation, that target has proved hard to hit.
European economies
What took them so long?
From The Economist print edition
The European Central Bank shrugs off a year of inflation-phobia
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CRITICS of the European Central Bank (ECB) have long complained that financial markets cannot tell what its officials are going to say next. The complaints have finally sunk in. As the ECB prepared to cut euro-area interest rates on December 5th, the first change in 13 months, the only question in bank watchers' minds, after so much official semaphoring, was the size of the cut. The ECB plumped for a bold half-point, to 2.75%, rather than a cautious quarter. That should stifle speculation that rates will soon fall further.
Since the bank's November meeting, when its customary “consensus” was harder than usual to reach, several members of its rate-setting governing council had hinted at a cut this time. Finally, on December 3rd, Wim Duisenberg, the ECB's president, talked unambiguously of strengthened evidence that inflationary pressures were easing, while “downside risks to growth” had not vanished. By central bankers' standards, the signal was deafening.
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But why did the ECB leave rates unchanged for so long? By contrast, the Federal Reserve—despite America's higher growth rate—has been willing to cut on several occasions. This year, the euro area has seen one disappointment after another, most obviously in Germany, its biggest member. For instance, unemployment there rose by more than expected in November. In the third quarter, as in the second, GDP in the whole euro area grew by only 0.3%—or 1.2% at an annual rate. The future looks no cheerier. On average, the panel of economists polled monthly by The Economist now predicts growth of a mere 1.5% in 2003. Six months ago, our forecasters expected 2.9% (see chart).
Fiscal policy is doing little to support economic activity. The euro area's stability and growth pact requires members to keep their budget deficits to below 3% of GDP. A breach necessitates swift remedial action—or the offender may risk paying a hefty fine. The French government, it is true, seems to be defying the pact. No wonder, given that French growth slowed to a 0.8% crawl (at an annual rate) in the third quarter. France wants to cut taxes, even though the European Commission, which monitors countries' compliance, thinks it may break fiscal limits in 2003. But in Germany, where a deficit of 3.8% is likely this year, the government is raising taxes, to the fury of businesses and many voters.
The ECB's line has been unsympathetic—not only holding rates, but repeating in schoolmasterly tones the importance of sticking to the rules. The commission recently proposed adjustments to the pact: but the 3% limit would stay, and countries with structural deficits, such as Germany, would still be expected to tighten policy, even in bad times.
One reason for the ECB's slowness, thinks Mark Wall of Deutsche Bank, is institutional. Unlike the Bank of England, it takes no votes (or has so far admitted to none); nor does Mr Duisenberg dominate the governing council as Alan Greenspan does the Federal Reserve's open-markets committee. Consensus is the rule—and a consensus for change can take time to build. Second, and perhaps more important, the ECB's treaty-prescribed duty is not to keep the economy at full steam but to maintain price stability, which it defines as a rate of inflation of no more than 2%. Despite the weakness of the euro-area economy and talk of the risk of deflation, that target has proved hard to hit.
In October inflation in the euro area was a stubborn 2.3%, up from 1.9% in July. Core inflation, which excludes energy, food, alcohol and tobacco prices, has been 2.4% or thereabouts for several months. But evidence of weakening activity has been building for months, and economists expect the slowdown, perhaps with help from a stronger euro, to pull inflation below 2% next year.
The main reason for inflation's stickiness, suggest economists at Goldman Sachs, is that unemployment in the euro area has risen only slightly—to 8.4%, from a low of 8% last year—as the economy has slowed. That has meant little downward pressure on wages. In turn, that has kept inflation in services on a rising trend, reaching an annualised rate of 3.5% in the three months to October. Moreover, slack in the economy affects inflation in services only slowly. Assuming that output dropped below capacity in the second half of 2001, the economists reckon that inflation in services should be about to turn.
Not surprisingly, wage moderation is a virtue that Mr Duisenberg preaches frequently. Wage stickiness could stop inflation falling much below 2%, and could justify the expectation of many economists that short-term interest rates will fall no lower than 2.75%.
That is hardly good news for those who would welcome easier money. But in a club of 12 diverse countries, not everybody wants lower rates. The 2.3% average for October hides a broad range, from 1.3% in Germany—where the figure has since fallen further—and Belgium, to 4%-plus in Ireland, Portugal and Spain. In Germany, where some see a risk of deflation, the case for lower interest rates is plain. Yet Rodrigo Rato, Spain's finance minister, said this week that, with credit growing by 13% a year in his country, a rate cut would be “not so great”. The ECB will never please everybody. Nor has it tried to.
Posted by DeLong at December 06, 2002 10:37 AM | Trackback