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Why ECB is likely to raise interest rate

Why ECB is likely to raise interest rate
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First Published: Fri, Jun 06 2008. 11 28 PM IST
Updated: Fri, Jun 06 2008. 11 28 PM IST
Here is a logical puzzle. The European Central Bank has a single mandate—keep inflation below 2%. The eurozone inflation rate has been above 3% since last November.
Central banks fight inflation by setting the overnight interest rate, currently 4% in the eurozone, well above the inflation rate. Now, why was the market shocked when Jean-Claude Trichet, the ECB’s president, said that a rate increase was likely? The surprise is unquestionable.
The market had been pricing in one 25 basis point rate increase early next year. After Trichet’s monthly press conference, it almost instantaneously moved to pricing in two over the next year, with the first almost certain to come in July.
One answer is that the market didn’t think the central bank would be so worried.
After all, while May’s 3.6% inflation rate is unlikely to be the peak, many economists expect price pressure to fade away after the commodity bubble is pricked. But that optimism refers to a year or two from now—long enough for higher prices to be matched by higher wages, the first step in a wage-price spiral.
The most likely explanation for the market’s surprise is that investors didn’t believe the ECB took its single mandate seriously. In practice, the central bank was not expected to run the risk of provoking a eurozone recession by increasing rates just when the economy was clearly slowing.
This reading of the bank’s approach isn’t totally irrational. Rates have long been much lower than anti-inflation purists would like. The ECB’s economic concern has been confirmed by its generous—and potentially inflationary—liquidity injections since the credit squeeze began last August.
So investors thought—wrongly—that the ECB is only slightly less relaxed about inflation than the US Federal Reserve. The US central bank is supposed to watch over growth and employment as well as inflation. That multiple mandate has helped it live comfortably with an inflation rate 2 percentage points higher than the overnight rate.
The answer to the puzzle is simple. The market has got its financial geography all wrong. Frankfurt is simply not Washington.
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First Published: Fri, Jun 06 2008. 11 28 PM IST