The excessively cautious bank

Date: 04/10/03

In monetary policy, actions speak louder than words

WIM DUISENBERG chaired his last monetary-policy meeting as the president of the European Central Bank (ECB) this week, before he hands over to Jean-Claude Trichet in November. The bank's press conferences are thus likely to be less exciting in future: Mr Duisenberg's gaffes have often rattled financial markets. And under his leadership, the ECB is also widely blamed for Europe's dismal economic performance. But it would be wrong to conclude that a central bank's monetary policy is only as good as its boss. The ECB has done a better job than is generally thought.

Many critics (including, at times, this newspaper) have argued that the ECB has been too slow to cut European interest rates. America's Federal Reserve has cut American rates by twice as much as the ECB over the past three years. Mr Duisenberg's hawkish tones have also reinforced the idea that the ECB consists of a bunch of inflation nutters. He once absurdly suggested that deflation was a “central banker's paradise”. And yet by many measures, the ECB's policy does not seem too tight. One widely used test is the so-called “Taylor rule”, which calculates the “correct” interest rate according to the amount of spare capacity in the economy and the inflation rate. A study by J.P. Morgan Chase concludes that, while the Fed's policy has broadly matched the Taylor rule in recent years, the ECB has actually cut interest rates by more than the Taylor rule would have prescribed.

Another claim is that the ceiling of the ECB's inflation target, of less than 2%, is too low. If the ECB had a higher target, in line with most other central banks, it could have cut interest rates by much more. In practice, though, the ECB has been a softer touch: during the past three years inflation has been below 2% in only five months. Yet doesn't the euro area's sluggish growth prove that interest rates have been too high? It is true that Europe's GDP growth has been much slower than America's, but these figures are distorted by America's faster population growth. Since the euro was launched in 1999, GDP per head in Europe has grown at exactly the same average pace (1.5% a year) as in America.

If policy has been too tight anywhere, this is true of fiscal rather than monetary policy. Europe's “stability and growth pact” forced governments to raise taxes during the economic downturn. But even here, things are not as tight as they seem. In the past year, Germany, France and Italy have broken the pact's ceiling on deficits of 3% of GDP. As long as this breach does not become reckless, or chronic, it should be welcomed.

People who live in glass houses

This defence of the ECB does not mean it is perfect. Far from it. Soon after he assumes the president's chair, Mr Trichet ought to set a higher inflation target with a mid point, rather than a ceiling of 2%, to guard against the risk of deflation in individual member countries, such as Germany. The ECB also needs to take more account of the rising euro, which is causing monetary conditions to tighten and so should, if it continues to rise, require the ECB to lower interest rates.

Other criticisms of the bank, though, seem weaker. Many argue that it needs to become more transparent. Yet it already is more transparent than the Fed: it does at least have a clearly defined inflation target and holds regular press conferences. Alan Greenspan, the Fed's chairman, gets away with his opaque utterances only because he is still seen by many people as almost divinely infallible. The ECB's focus on monetary growth in addition to its inflation goal is often criticised as undermining its transparency. Yet keeping an eye on the pace of growth in money (and hence credit) can provide a useful check against asset-price bubbles, which have clobbered Japan in the late 1980s and America in the 1990s.

Today the ECB may want to avoid the situation in America, where big interest-rate cuts have encouraged a huge build-up in debt, increasing the risk of a harder economic landing when rates start rising. The Fed's monetary policy of recent years is much admired, yet arguably it helped to create the stockmarket bubble of the 1990s and is currently feeding a housing bubble. The truth may be not that the ECB that has cut interest rates too little, but that the Fed has cut them too much.

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