Euro-area interest rates

The ECB's second interest-rate rise in three months is not as mad as it seems

IN THE few days before Lent the stereotype of Germans as a people without humour takes a thorough pasting. In the Rhineland and the south, it's carnival time. The streets are filled with parades of elaborate floats, there's lots to eat and drink and nobody does a stroke of work. Men in ties are liable to have them snipped off by scissor-toting women. On Ash Wednesday order is restored. This year the European Central Bank (ECB), in Frankfurt, did its bit for renewed sobriety. On Thursday March 2nd its mainly male policymakers tightened their (intact) neckwear and raised interest rates by a quarter-point, to 2.5%.

Although the increase, the second in three months, was widely expected, many commentators think it was a mistake. In the fourth quarter of last year euro-area GDP growth slowed sharply, to only 1.2%. German consumer spending fell for the fourth quarter running, the first time this has happened since at least 1960. Inflation seems to be under control. New figures this week showed that the euro area's core rate of inflation (ie, excluding energy, food and tobacco) fell to only 1.2% in January, the lowest for nearly five years.

Nevertheless, the ECB has some sound reasons for tightening policy. First, it places more weight on the headline rate of inflation than on the core measure. At 2.3%, the headline rate is well above the bank's target of close to, but less than, 2%. The ECB remains worried that rising energy prices will feed into general prices.

Second, even after this rate rise, policy is lax by past standards, despite what the ECB's critics say. Real interest rates (ie, after allowing for inflation) have been negative for the past two years and even now are barely positive (see chart). In other words, monetary policy is still stimulating demand. A super-loose policy was necessary when there was a risk of deflation, but not now. It therefore makes sense to nudge rates gradually back to more normal levels. Most economists think that the "neutral" rate of interest, which would neither stimulate nor restrain demand in the euro area, is now more than 3% (in nominal terms).

The ECB is also more confident that economic growth is picking up. GDP figures are like a glance in the rear-view mirror: they tell you where the economy has come from, but not where it is or where it is going. Experience also suggests that first estimates of GDP growth are almost always revised upwards. This is why policymakers now pay close attention to surveys of business and consumer confidence.

The index of German business confidence calculated monthly by Ifo, a Munich research institute, is at its highest since the post-unification boom in 1991. If the index's past relationship with GDP held, it would signal growth this year of 3-4%. Admittedly, businessmen's glee partly reflects their optimism about global growth prospects and their profits are benefiting from production in low-wage countries. This may make the Ifo index a less useful guide to domestic economic prospects than it used to be. Nevertheless, the surge in the index is not confined to manufacturing: in particular, retailers are more confident than they have been for six years. Surveys of German consumer confidence have also perked up this year.

Germany, however, is not the whole zone. Some economists think that Germany is growing largely at the expense of its euro-area neighbours, thanks to improvements in its competitiveness. If that were right, prospects for the zone as a whole would be little brighter. It is true that Germany has a big current-account surplus, while France, Italy and Spain all have deficits, and this might suggest that production is being shifted to Germany.

Yet business and consumer confidence seem to be picking up across most of the euro area. The European Commission's industrial and consumer survey for February found that economic sentiment improved in France and Italy (the second- and third-biggest economies) as well as Germany. Perhaps the best news was a rise in employment expectations of both industrial and service firms. Economists at J.P. Morgan forecast that Germany's GDP will grow at an annual rate of 2.7% in the first half of 2006, and the euro area's by 2.6%, well above the 1.75-2% range in which most estimates of its sustainable potential lie.

Money, it's a crime

Another important factor behind the rate rise is that compared with other central banks the ECB keeps an especially close eye on the growth of money and credit, which can provide useful information about longer-term inflation risks. In the year to January, lending to households grew at an annual rate of 9.4%, the fastest since 2000. The pace of growth of M3, the broad measure of the money supply, quickened to 7.6%. It has been well above the ECB's target for five years.

The central bank's immediate concern is that excessive growth of money and credit can spill into asset prices. European share prices have climbed quickly in the past year, with German equities up by almost 40% since January 2005. But an article in the bank's latest Monthly Bulletin shows that it is the housing market that the ECB is watching most keenly.

Recent years have seen big jumps in home prices in France, Spain, Italy and Ireland. A stagnant market in Germany limited the average rise across the euro area last year to 7%, much less than in America (see next article). The ECB frets that households may be borrowing too much to buy homes; if house prices fall in future, the zone's economies could be hurt. It estimates that in 2004 the average property in the euro area was overvalued by at least 15%, and homes in Spain and France by almost 30%. Property is surely even more overvalued by now.

This does not mean that the ECB is about to start targeting house prices, but it is another reason for it to make monetary policy a bit less loose. After all, inflation would be about half a percentage point higher if house prices were included in the euro area's consumer-price index, as they are in America.

Financial markets are betting that interest rates will rise to 3% by December. Capital Economics, a London research firm, expects them to reach 3.5%. That would still be low by past standards and less than America's current 4.5%. For most of the euro area, the effect on demand would be modest. But there are two worrying exceptions. In Ireland and Spain home prices are the most overvalued in the zone; worse, the bulk of mortgages are at variable rates. Elsewhere, most mortgage rates are fixed. A rise in ECB rates from 2% to 3.5% seems modest, yet it implies a rise in mortgage interest payments (assuming a rate one percentage point above the central bank rate) of 50%. Irish and Spanish borrowers have taken on so much more debt in recent years that their extra payments would correspond to an increase in interest rates in the early 1990s from 10% to 15%--enough to cause considerable pain.

If rising interest rates hurt these economies by much more than those of Germany, France and Italy, there will be nothing the ECB can do to lessen homebuyers' misery. Its job is to set rates for the whole of the euro area. Having enjoyed the benefits of Europe's "one size fits all" policy when money was cheap, Ireland and Spain are about to suffer the cost.

The ECB's second interest rate rise in three months, 2 March 2006, is not as mad as it seems.