European Central Bank masters the black arts of market manipulation

Date: 18/11/1999

The ECB has had a baptism of fire since it was created less than two years ago and insiders say members of its governing council have endured a 'very uncomfortable' few months since they decided to cut interest rates in April. But recent events have demonstrated that it has learnt from its mistakes. Tim Jones reports

THE European Central Bank may be only 16 months old, but it has already proved that it can learn from its mistakes.

In private, at least some central bankers confess that they mismanaged their 0.5-percentage-point cut in interest rates to 2.5% in April.

A few private-sector economists were anticipating a monetary policy easing but not on that scale, and nothing in the stream of statements, speeches and interviews by ECB board members beforehand had begun to hint at it.

So when the decision was announced, it took the money markets by surprise. "It looked as though they had seen something the rest of the world hadn't," says a former senior central banker. "There was no expectation management at all, which could cause problems in the future because markets will not believe what they say."

Seven months on, when ECB governing council members agreed two weeks ago to reverse the decision they took in the spring by putting their official rates up by half a percentage point, they proved themselves more than adept in the black arts of market manipulation.

"We deliberately changed the tone of our assessment and of its presentation, starting on 15 July in a press conference," admitted ECB President Wim Duisenberg on the day rates were raised. "We do want to be predictable, to the maximum extent possible, because only in this way can we also succeed in being credible in the markets."

For a new central bank conducting monetary policy in a conjured-up 11-nation wholesale money market without the Bundesbank brand name attached, the ECB has been incredibly successful. Futures contracts - the instruments investors buy to protect themselves against unexpected developments - have, at worst, forecast interest rates at 4.5% by the end of next year, while ten-year government bond yields have dipped to post-war lows at around 5%.

Even the mismanagement of the April interest-rate cut did little to dent the bank's long-term credibility. German Finance Minister Oskar Lafontaine, who had been badgering the ECB to reduce rates, had left the government before the decision was taken and the bank was seen to be acting merely in support of its mandate: to keep annual euro-zone consumer price inflation within a 0-2% range.

But insiders say it has nevertheless been a "very uncomfortable" few months for most members of the governing council. "They have, to a large extent, been flying blind," said one. "The economists have done everything they can to make the data reliable, but they simply could not rely on it. They had to rely a lot on instinct and anecdotal evidence such as confidence surveys, reports on wage demands and so on."

That, according to Vice-President Christian Noyer, has now changed. The ECB money-supply targeters have finally found their holy grail: a reliable M3 monetary aggregate.

M3 - which includes banknotes and coins in circulation, deposits cashable within a few months and short-term money market instruments - is a man-made measurement of money-supply growth, a precursor of oncoming inflation.

The trouble in the early days of the euro zone was that it was impossible to predict how much the M3 aggregate would be shaped by consumers, industries and investors reacting to the creation of economic and monetary union itself. Months of refining within the Eurotower have taken the 'noise' out of the data and left the council with an efficient predictor of inflation.

Of course, that depends on whether council members trust even reliable monetary aggregates. Some do not. Others, including chief economist Otmar Issing, swear by them.

It was that figure which drove this month's rate rise. When it became apparent that the three-month average of the annual M3 growth rate in July to September had hit 5.9% - once again above the bank's benchmark of 4.5% - the council had all the evidence it needed to justify a hike in rates. The gap between the benchmark and reality had been steadily widening throughout the year.

Underlying the M3 growth rate was a 13% annual acceleration in what the bank calls the "most liquid components" - currency in circulation and overnight deposits - which were being driven by historically-low interest rates and the first signs of economic recovery in Germany.

Hawks on the council had been fretting for months about the sustained strength of credit growth, which was up more than 10% over the year since early spring. The long-depressed oil price had turned around in a big way and Issing warned the council that this could quickly translate into higher wage settlements as trade union negotiators saw an opportunity to match the rising cost of driving and heating. The ECB never anticipated that its 2% inflation ceiling would be breached next year, but forecast 1.75% - a rate which left only a tiny margin of error if an unexpected price shock came along.

With all the information save the September M3 number in the bag, a few of the hawks must have had some sleepless nights when they held back from a rate rise in October. Although cutting interest rates made the fledgling institution loved in the euro zone, there is nothing that makes a central banker more comfortable than tightening policy. In New Zealand, missing the inflation target actually leads to cut in the central bank governor's wages.

It had been a long time since interest rates had been raised in continental Europe - 9 October 1997 to be exact, when the Bundesbank lifted its key rate for influencing money market conditions by 0.3 of a percentage point to 3.3%. So long indeed that two of those round the table at last week's meeting had never had to sanction a rate rise before.

The last one to do so was the monetary 'rambo' herself, ECB executive board member Sirkka Hamalainen, who decided only nine months before Finland joined the euro zone that she should jack up the country's money-market tender rate by 0.15 of a point to 3.4%.

When it came to this month's council meeting, nobody wanted to leave rates unchanged, but a 'discussion' ensued over whether to make it 0.25 of a point or 0.5.

The ECB's Kremlinologists believe that those who favoured the lower figure were Bundesbank President Ernst Welteke and the Bank of Italy's Antonio Fazio, but neither has admitted this.

The argument was won by those who wanted to make it clear that the rate rise would be the last for some time. At the back of their minds was a desire to avoid any speculation about another rate cut around the turn of the millennium, when they could have more than enough cash-liquidity problems on their hands.

Nevertheless, Duisenberg wanted to avoid a repetition of his remark in April that "this is it"; i.e. that rates would not fall again. It appears, however, that he was too cryptic in his comments to the press and Noyer felt obliged to tell Italian daily newspaper Il Sole 24 Ore within days that he did not expect another rate increase in "the coming months" barring unforeseeable changes.

Major feature. The ECB has had a baptism of fire since it was created less than two years ago and insiders say members of its governing council have endured a 'very uncomfortable' few months since they decided to cut interest rates in April 1999. But recent events have demonstrated that it has learnt from its mistakes.