Trichet’s Double Bind

By Allston Mitchell, February 2, 2011

Jean Claude Trichet  -  photo by Monika Flueckiger

Jean Claude Trichet - photo by Monika Flueckiger

The President of the European Central Bank faces a dilemma - to fight rising inflation in Europe by raising interest rates or to keep rates low to make life bearable for the highly indebted "peripheral" countries like Ireland, Portugal and Spain.

Jean Claude Trichet, the President of the European Central bank would no doubt prefer to turn his mind to cooling down the European economy by raising interest rates from their current historical low of 1%. With all the money that has been flooded into the European economy to stabilize a teetering banking sector and government sovereign debt, he will feel it is high time to start pulling in the reins. Not so easy.

The idea that is being floated is to raise interest rates by one percent up to 2% as a response to recent data that saw inflation rearing its ugly head in no uncertain terms.

Prices in the euro zone were up 5.3 % year-on-year in December. The oil price has seen a rise of over 7% in January 2011 alone, partly due to the threat of the closure of the Suez Canal and the ongoing tightness in supply.

Under normal circumstances the choice would be a simple one: raise interest rates to combat inflation, but with Greece, Ireland, Portugal, Spain and Italy all struggling to service their debt, any added pressure from the ECB would be most unwelcome in such a delicate, if not dangerous, moment. It would not only be governments that would suffer but home owners too, at least those with floating rate repayments.

What is to be done? The ECB has a very clear but rather limited mandate to ensure price stability in Europe, unlike the Federal Reserve in the USA which has a broader mandate “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” The ECB has basically just one weapon with which to fight a very big battle – interest rates. The ECB’s job is to tackle inflation but does it have to be at the expense of the survival of the economies of certain member states? It is a frightful dilemma.

The danger signals are clearly there but are not yet alarming. The ECB aims to keep inflation under 2%. That limit has now been broken and has reached 2.2%. The ECB is talking the problem away by saying that the energy price inflation is “imported” and “short term”. Basically this means that when winter is over, people will stop buying oil and gas to heat themselves, taking the pressure off energy prices. So the bank is asking for a bit of short term cooperation, perhaps until June when prices should move lower.

The ECB wants to hit this problem firmly on the head as it wants to avoid the knock-on effects of this energy inflation which might well lead to wage hike demands and rising retail prices in foodstuffs which are already moving higher. The current energy inflation might be imported from abroad in gas and oil prices but a rise in interest rates could give the Euro a boost so as to obviate the consequences of rising energy prices denominated in dollars.

The ECB has something of a thankless task. Unlike the Federal Reserve, Trichet does not have one homogenous economy to manage but several, and they are all very different in nature. The Fed is obliged to convince a small group of law makers of its thinking but the ECB has to manage the demands and expectations of all the politicians and central bankers of the EU states. If Germany needs price stability and Ireland needs a flood of cash to save itself, how on earth do you come up with a standardized and homogenous policy?

Inflation is a merciless beast and the ECB cannot afford to let it run ahead of their policy making decisions. They have to act in a pre-emptive manner which leads many to believe that a rise in interest rates will be forthcoming soon. The ECB traditionally does not tinker with rates as the Fed tends to do. They are in for the long stable haul. They want to get it right at just the right time. So the “peripheral” indebted countries in the EU may just have to suffer. The ECB can hardly be said to be leaving them in the lurch as it has already bought over 70 billion euros of their debt on the open market to keep sovereign debt prices down. Nevertheless somebody has to be sacrificed on the altar of price stability and it won’t be Germany.

1st February 2011

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