December 01, 2005
From the desk of Jane Galt:Europe's monetary policy
The European Central bank finally raised interest rates this morning, the first time it has done so in more than five years. Jean-Claude Trichet, the president of the bank, is trying to establish credibility as an inflation hawk by leaping on any sign of inflation before inflationary expectations become established.
But big eurozone economies like France and Germany are only now recovering from the post-boom downturn, and a hefty part of that recovery has relied on a weaker euro, which has boosted exports, particularly from Germany. Mr Trichet is in an unenviable position, trying, in effect, to reassure markets that he will fight inflation, without raising rates high enough to cause a credit contraction or an appreciation in the currency, which could push eurozone economies back into the doldrums.
Mr Trichet faces the same problem that other central bankers confront: how to fight inflation driven by high oil prices. On the one hand, oil-driven inflation doesn't mean that the money supply is too loose. On the other hand, oil-driven inflation can entrench inflationary expectations, which are very costly to quell once they are established. And some economists argue that the productivity shock of high oil prices in fact increases core inflation, even as it slows economic growth. Most central bankers are supposed to balance price stability against employment and economic growth. What does one do when they're both moving in the wrong direction?
Posted by Jane Galt at December 1, 2005 11:08 AM | TrackBack | Technorati inbound linksIsn't the bigger part of his problem that the Euro zone includes both stagnant and booming economies that cannot both be served by the same monetary policy?
Posted by: AT on December 1, 2005 11:42 AMA more immediate concern is that fiscal policy is awry. Were Eurozone countries to keep to the Maastricht criteria, reliance on tighter money to keep a lid on inflation would be less of a necessity and burden. But as many do not meet the targets, there is too much inflationary liquidity created.
Posted by: Garth on December 1, 2005 03:27 PMThe ECB's quandary is made more difficult by the fact that the Bank has repeatedly missed its inflation target. The transmission mechanism of ECB policy rates to inflation runs partly through expectations formation. And the higher the Bank's credibility, the more powerful the effect of its actions and statements on expectations. If the ECB were highly credible, it might easily get away with letting "transitory" shocks like an oil price spike pass without a policy reaction. Expectations would remain anchored by the ECB's inflation target. Unfortunately, Trichet's ECB has fairly low credibility. The reaction required to stabilize expectations in the face of a supply shock will need to be more dramatic and will therefore run more risk of killing Europe's stuttering recovery.
Posted by: Ben on December 1, 2005 06:04 PMWhat does one do when they're both moving in the wrong direction?
Easy... They should give up, disband the bank, and go back to a 100% gold backed currency.
Posted by: Libertarian Jason on December 1, 2005 07:31 PMLet us just pray that silly Mr Blair doesn't invite them all to abandon the euro and join the pound sterling.
Posted by: dearieme on December 1, 2005 08:18 PMJane,
I'm a long-time reader, and want to thank you for all the time you put in on this blog.
When you write "Mr Trichet faces the same problem that other central bankers confront: how to fight inflation driven by high oil prices.", it sounds like you're suggesting that inflation is caused by rising prices.
I'm of the opinion that inflation is caused by an unwarranted increase in the money supply, and that rising prices are the natural result of said increase.
In other words, rising prices are the result of inflation, but aren't inflation itself.
Any thoughts?
Posted by: Felix on December 1, 2005 10:00 PMComments are Closed.