In the days leading up to the European Central Bank’s rate decision
on July 3rd, 2008, many political leaders around Europe publically
pleaded for the ECB to leave interest rates unchanged. Among others,
French President Sarkozy voiced the opinion that the recent rise in
inflation was due primarily to the spike in commodity prices.¹ As such,
Sarkozy suggested that though hiking interest rates would not really
help in lowering inflation, it would adversely impact growth. The ECB
went ahead and hiked interest rates anyway, and looking back now, a
month and a half later, we can begin to asses two issues: whether the
rate hike was the right choice, and what the ECB should do now.
Looking at the statistics over the past few months here,
there are several main points to take away. The first is that President
Sarkozy’s nightmare seems to have become reality; growth has
suffered. In the Euro-Zone, as well as in its three largest economies,
Gross Domestic Product (GDP) fell in the second quarter. However, the
second chart (showing Consumer Price Index) indicates that inflation has
either slowed or halted its rise in these same economies.
Given that the ECB is bound to target inflation first and foremost,
the above statistics would imply that the recent rate hike was the
correct move – though clearly not without consequences. Inflation has
slowed in its rise, and while next months’ numbers will bring about
more clarity to the situation, it seems that the rate hike had its
desired impact. Now, the more prudent question is if the long-term
repercussions of the hike will outweigh the benefits. Will the rate hike
facilitate Europe’s slide into recession? It is certainly possible.
Italy is already on the brink of recession, and France’s large decline
in growth indicates that it is also in trouble.
One important note about the CPI numbers is regarding the source of
the recent slowdown in the rise of inflation. As the price of oil
started to fall around the same time as the rate hike, it is unclear
which – or both – influenced inflation. As it is probable that both
events have had an impact, it is unknown just how useful the rate hike
has been thus far in thwarting inflation’s rise. However, considering
the magnitude of oil’s fall in recent weeks, it is safe to assume that
it has had a sizeable impact on the slowing of the rise of inflation.
The fall in oil price will help alleviate inflationary pressures anyway;
hence the ECB should switch focus to the other problem of falling
growth.
At this point, the best move for the ECB would now be to cut rates.
While the ECB was founded with an inflation-targeting mentality, it is
too dangerous to ignore growth at this time. The US (seemingly) has
recently skirted around a recession by aggressively slashing rates and
supporting wounded members of the banking system. By admitting the
problem early on, the US avoided significant damage to the financial
sector, with only one of the largest banks going under. Europe, however,
has taken a different path, and now finds itself on the precipice of
recession. This proposition to focus on spurring growth comes from the
belief that the inflation problem can largely solve itself as long as
energy costs continue to fall. With oil prices down over 20% from their
all-time high, it seems apparent that this fall in price will eventually
be filtered down to consumers.
Proponents of the ECB’s generally “hawkish†nature would
certainly throw out economic theories such as the J-Curve to support
their position. This theory suggests that through a devaluation, a
country can actually increase their trade balance (and hence GDP) via
increased exports and decreased imports. There is potential for this to
occur, but that would involve a devaluation of the Euro that many
Europeans would certainly love to avoid. Furthermore, this process of
GDP rising on its own could take an unacceptable length of time. Just
recently, the ECB finally admitted the problems that the Euro-Zone now
faces.² It is time that the ECB make a bold move and cut rates, sending
a signal to the markets that they will not stand by and watch Europe
sink into recession.
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