How long can the ECB continue to rule by consensus?

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Series Details Vol 7, No.10, 8.3.01, p12-13
Publication Date 08/03/2001
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Date: 08/03/01

The European Central Bank has so far resisted the temptation to follow the rate-cutting lead of the US but its governing council could soon face its first real differences of policy opinion. Tim Jones reports

Wall Street has sneezed. Shouldn't the eurozone be catching a cold?

Ever since the US Federal Reserve's Chairman Alan Greenspan tarnished his halo and was forced to slash interest rates three days into the New Year, opinion-formers have been waiting for an echo at the European Central Bank.

After all, we're supposed to live in an unprecedentedly interwoven world economy; to convene an economic conference without the word 'globalisation' in the title would be as unthinkable as leaving out the letter 'e' before an online information policy initiative.

Yet, 64 days since the Fed's panic rate cut, the ECB is holding fire.

Why? Quite simply, discomfort among the bank's 18-member governing council, the decision-making body that meets every fortnight, that the general price level for consumer goods and services (inflation) is rising too quickly and could threaten the ECB's primary mandate: to protect the domestic value of the euro. The bank defines 'price stability' not as flat prices but, to take account of unexpected shocks and the need for productive investment, as consumer price inflation of up to 2% over a year.

For now, these fears outweigh any suggestions that the long American boom will turn to bust and engulf the world. "At this juncture, there are no signs that the slowdown in the US economy is having significant and lasting spillover effects on the euro area," said ECB President Wim Duisenberg at his monthly press conference last week.

Duisenberg dismissed the continued differential between euro-zone and US-market interest rates - still around 0.75 percentage point - even though this continues to make the dollar more attractive to speculative investors than the euro. "The European economy, even after taking financial market movements into account, is a closed enough economy to justify us ignoring those differentials," he said.

Surveys suggesting a decline in business confidence - the benchmark euro-zone indicator slid to 102.7 in February from a revised 103.1 in January - are still in the minority compared with hard data showing economic resilience. At the same press conference, Duisenberg stated that the bank's current benchmark interest rate was high enough to meet this target. "That assessment is based on the assumption that interest rates will remain unchanged," he said.

At first glance, the statement is hot news: interest rates will remain at 4.75%. At second, it becomes evident that to have said anything else would be a confession from the ECB's president that interest-rate policy was wrong. Duisenberg is fast acquiring Greenspan's answer-evading skills; "if you understood me, I must have made a mistake," the Fed chief once famously told a Congressional committee.

Behind the scenes, the truth is that most members of the governing council fear cutting rates when the rate of annual increase in the harmonised index of consumer prices (HICP) is still above 2%; such a move would send out the wrong signal to wage negotiators and company price-setters.

"I am personally afraid that the longer people see inflation rates of 2%, it gets into their frames of reference and it changes expectations," Matti Vanhala, Finland's representative on the council, said in January.

The HICP growth rate is slowing. Data released last week showed the annual rate decelerating to 2.4% in January from 2.6% in December and a high of 2.9% in November. This is largely the result of a cooling in the price of oil and a resurgence of the euro, whose weakness had caused the dollar, yen and sterling-denominated price of imports to rise. While on the wane, the figure is still markedly over 2% and the average also masks much faster rates in key euro-zone economies such as Italy at 2.7%, Spain at 3.8% and the Netherlands at a storming 4.5%.

"Inflation will be too high for them to lower interest rates until late April or early May mostly because of wage demands being too high," says Michael Schubert, ECB-watcher at Commerzbank in Frankfurt. "We will see key wage negotiations in Italy, Spain and France this spring although most of the German settlements last year were for two years." The temptation for firms to cave in will be strong.

Despite survey evidence of a downturn in confidence imported from the US, most economists believe the euro-zone still has a 'positive output gap' - meaning that the economy is producing at a pace that would historically generate inflation. At the same time, firms are feeling constraints on their capacity to produce goods and services.

The bank's favoured tool for detecting inflation before it comes - the amount of money freely circulating in the euro-area economy defined as paper bills, coins, bank deposits and forms of quickly cashable debt (known to economists as 'M3') - is also outside the comfort zone.

The annual growth rate averaged out between November and January was 5.0%; down from the October-December 5.1% average admittedly but still 0.5 percentage point above the ECB's 'reference value'.

"We do not see signs that the very gradual slowdown of M3 in the direction of the reference value might be interrupted in the near future," said Duisenberg, but they would hate to ease rates unless the three-month average at least had a four before the decimal point - which is as close to a statistical certainty as possible at the beginning of April.

The final jigsaw piece the council needs to justify a rate cut is a sign from big euro-zone governments that they will not relax public-spending curbs this year.

The new round of three-year budget plans going through European Commission vetting do not bode well for convincing Frankfurt of finance ministers' budget-cutting credentials. So far, Portugal has been given a tongue-lashing for relying too heavily on rising tax revenues to plug the deficit, Spain for failing to douse inflation and Belgium for taking an eye off debt-reduction.

All this means that majority opinion on the council is still not convinced that it can keep inflation below a 2% ceiling with interest rates at 4.5% or below given foreseeable risks.

A month or two from now, if those risks fail to materialise, the ECB may face the first real differences of policy opinion on the council since the euro appeared two years ago. Until now, every interest-rate decision has been taken without a vote. Consensus has ruled.

If the US juggernaut does stall and the effects are felt most severely in traditional exporters Germany and Italy, that consensus could start to unravel.

That's when the ECB will start getting really interesting.

The ECB is to launch an €80-million publicity campaign to increase awareness that the euro notes and coins will be introduced on 1 January next year. Surveys suggest that just 40% of the euro-zone population knows this - and that support for the currency is falling in most member states.

Asked last week whether this concerned him, Duisenberg was unusually straight-forward in his reply: "It does not."

Major feature. The European Central Bank has so far resisted the temptation to follow the rate-cutting lead of the US but its governing council could soon face its first real differences of policy opinion.

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