ECB's Policy Stance

The European Central Bank (ECB) kept interest rates at 4 percent last Thursday to curb inflation. ECB President Jean-Claude Trichet played down investor speculation that he will cut rates soon. The Euro jumped to a new high against the dollar, rising to almost 1,54. After leaving the key rate at six-year high of 4 percent, the ECB revised up its inflation projection for this year to about 2,9%. At the same time the ECB reduced its prediction for growth to about 1,7% for 2008 and 1,8% for 2009.

But why is the ECB reluctant to follow the Fed in lowering rates? While the oil prices drives inflation to a 14-year high of 3,2 percent, the current appreciation of euro against dollar will dampen European export growth. The ECB President emphasised that “maintaining price stability in the medium term is our primary objective in accordance with our mandate”.


Fed Chairman Ben S. Bernanke sharply cut the benchmark lending rate by 225 basis points to 3 percent since August in response to the turmoil in financial markets and to fight a possibly worst economic slowdown. The ECB, based in Frankfurt will keep rates steady, despite the Fed’s recent determined moves. In combination with Fed’s interest rate cuts Congress and the White House even reached an agreement on a stimulus package.

However the ECB is against public spending as a form of economic stimulus. Why? According to the theorem of the ECB there are structural reasons (“rigidities”) which prevent economic growth and cause stagnation and high unemployment. An expansive economic approach, regardless whether fiscal or monetary, is not capable to support economic growth and job market. Therefore Mr. Trichet always closes his introductory statement for his interest rate decisions with some phrases regarding “structural reforms”. Always. Mr. Bernanke expect inflation in the United States to fall as demand eases off during a slowdown. Mr. Trichet, by contrast, doesn’t believe on that notion that inflation automatically falls, when growth goes down. The differences are ideological. That’s why the ECB and its supporters always call for reforms for the job market. To spite empirical evidence the ECB speaks up for making the job market flexible first and then upturning the economic growth. And so Mr. Trichet is against minimum wage legislation. That’s why he always warns form “second-round effects”.

The ECB is surely feeling the slowdown in the United States economy. But Mr. Trichet seems to believe that the European Economy is strong enough to head off the risks of a spillover into the Euro Zone. Actually Europe cannot decouple itself from a possible recession in the United States. The last recession in the United States took place in 2001. Five months later, in May the ECB started easing its benchmark interest rates, despite the inflation rate was running distinct above 2,5 percent. Therefore we expect the ECB to cut its interest rate at the end of the second period, while ECB President doesn’t hint at any interest rate action in the near future.