The ECB finally raise rates - but should they have?

After leaving interest rates unchanged for more than two years, the European Central Bank yesterday raised official interest rates by 25 basis points to 2.25%. The decision has sparked some interesting reactions. European share prices have rallied, the euro fell, and the ECB's Noyer, Weber and Liebscher all rushed to defend the decision. Although ECB President Jean-Claude Trichet claimed this was not the start of a rate tightening cycle, markets have largely priced in two more quarter point hikes in the first half of 2006. The Economist summarises Trichet’s dilemma well:

The bank is trying to establish its credibility as an inflation hawk, but this may be hard to do without endangering the fragile recovery in some of the euro zone’s biggest economies.

Also worth reading is Edward Hugh's long post, The Most Bizarre Monetary Policy DecisionOf Recent Times? Ed does not mince words:

My own view is that this has been an extremely foolish move on the part of the Bank, and - as Munchau indicates - they are playing with fire here... If they have read the tea leaves badly (and I think they have) and if the German data fail to improve and the Italian data turn downhill again (which I think might well happen) then this may be the last time the ECB will dare to make a decision which isn’t approved of by the finance ministers first.

So was this a balanced risk? Was it wise - or even, god forbid, prudent - to try and call the shots when only a quarter point is in play. I think not. If I was going to make a risky call, one which could threaten my long term independence methinks I would want to do it for something a bit more susbtantial.

I would also recommend Dave Altig's two posts, Jane Galt, and Carter Dougherty's piece in the International Herald Tribune, Anchoring inflation in Europe

But beyond stern intonations from Jean-Claude Trichet, the bank's president, that "we do what we have to do," the ECB's intentions remain muddled - odd, economists said, for a central bank that prides itself on its scrutability.

And unlike the U.S. Federal Reserve, which telegraphs its plans far in advance, the ECB's strategy for the future remains unclear. It has raised rates once, but it cautioned this week against expectations of a series of increases. It arrived at this point by urging "strong vigilance" against inflation, but after the announcement Thursday it dropped such language from its communications.

In the end, Thursday's move was evidence of nothing so much as a monetary policy that is neither fish nor fowl. As the ECB worries that it might have to clamp down on cheap credit to contain inflation, it also frets that no one can predict how much tightening of the money supply the still-weak euro-zone economy can take.

UPDATE: Bloomberg columnist Caroline Baum defends the ECB from its citics, Score So Far Is ECB, 1; Unsolicited Advisers, 0.

Was the ECB justified in raising rates today or just being a nervous Nellie? Inflation in the euro zone rose 2.4 percent in the year ended November, the 10th consecutive month above the ECB target, while core inflation, excluding food and energy, rose 1.4 percent in the 12 months ended October. The ECB aims for inflation of less than 2 percent over the medium term.

Critics point to Europe's slow economic growth as a sign the ECB is overreaching. Real gross domestic product in the 12 countries using the euro rose 1.6 percent in the third quarter from the same quarter a year earlier. Year-over-year growth has exceeded 2 percent in only one of the last 18 quarters.

It's hard to pin slow growth on monetary policy or the interest-rate structure, with short-term rates anchored at 2 percent since the middle of 2003 and long-term rates in the neighborhood of 3.5 percent.

Europe's finance ministers would be better served by putting their own houses in order rather than telling Monsieur Trichet how to run his.

Comments

[eurocent]

well, in Spain we have 3.4% inflation, and almost 4% in regions like Barcelona. We have gone wildly into debt to buy houses at Californian prices with our Spanish salaries (which are 60% smaller).
While Spain might need this tightening (and more) it is true that Germany and France already have too many problems.

[Claus Vistesen]

"While Spain might need this tightening (and more) it is true that Germany and France already have too many problems."

This is the real problem for Trichet and the ECB in my opinion. Adjusting a quarter procent to meet a monetary target of 2% inflation for the whole Eurozone is very abitrary when we take into account the condition of the indivdual economies - what about a growth target?