Bosses urge ECB to pause for thought

Exchange rates rarely feature in formal economic forecasts. They are too unpredictable. But this does not mean that the small print on the final page of the autumn economic outlook from UNICE, the European employers’ group, should be ignored.

For underlying the tiny print is a big issue. How much attention should be paid to the threat to net exports, and so to growth, from a surge in the valuation of the euro on the foreign exchange markets, and how should the European Central Bank (ECB) conduct its monetary policy to counter this threat?

UNICE asked its members what they expect the dollar/euro exchange rate to be in March of next year and at what level the euro/dollar rate would "significantly hurt" the European economy?

The answer from its members to the first question is around where it is today, namely with a euro buying $1.30.

As to the second question, the numbers range from around $1.30-$1.50, with most national business federations plumping for between $1.30-1.40. Put simply, business is not keen to see the euro exchange rate rise.

No surprise then that Ernest-Antoine Seillière, the Frenchman who heads UNICE, has decided that now is the time to let the ECB know that European business is running out of patience with interest rate increases.

For higher interest rates are likely to lead, inter alia, to a stronger euro.

Launching the forecasts at a press conference this week Seillière announced that it would be, in UNICE’s view, time for the ECB "to pause" in its tightening of monetary policy after the increase which is expected next month to take its key policy rate to 3.5%, up from the 2.25 % level it set 12 months ago with its first increase for two years. It is highly likely, too, that in the next couple of weeks a number of Eurogroup finance ministers (UNICE had discussions with Eurogroup President Jean-Claude Juncker before it published its report) will climb on the bandwagon. But will the ECB listen to these pleas for a pause?

Forecasts for growth and inflation in Europe next year do not differ wildly from UNICE’s (see table), with most expecting real gross domestic product (GDP) to increase by around 2.0% and inflation to be close to the same level. But is this short-term inflation outlook comforting to the ECB?

Clearly not, for the ECB is worried that rapid money and credit growth is signalling that the inflation rate could be significantly higher.

Last week (9-10 November) the ECB convened in Frankfurt arguably its most prestigious economic policy conference ever, which it titled "The role of money: money and monetary policy in the twenty-first century."

It invited along Ben Bernanke, the chairman of America’s Federal Reserve Board, Zhou Xiaochuan, governor of the People’s Bank of China and Kazumasa Iwata, deputy governor of Japan’s central bank. In short, representatives of the Group of Four currencies which are destined to shape the world economy in the next two or three decades, were all in the room.

The message from Jean-Claude Trichet, the ECB president, could not have been clearer: yes, we know that we are criticised for paying attention to our second monetary policy pillar, and yes, the ECB knows that most academic theorists (and the Fed itself) pretty much dismiss money and credit as a focus of monetary policymaking strategies.

But, the fact is, in the past three years, on specific occasions, money and credit figures have at times played a decisive role in our judgement of whether or not to raise or lower euro interest rates, the last time in December of 2005.

Then critics (including incidentally Juncker) said (wrongly) a rate increase was not needed.

By implication, Trichet was putting those economists who have not been listening on notice that they should take seriously, as the ECB is doing, the inflationary potential of the excessive growth of money and credit in the eurozone and the capacity of such growth to unbalance the financial sector and lead to asset booms and busts.

As the ECB says in its November Bulletin, "the rate of monetary and credit expansion remains rapid, reflecting the still low level of interest rates in the euro area and the strengthening of economic activity". It added "annual inflation rates are projected to remain elevated in 2006-07 with risks to this outlook remaining clearly on the upside". Earlier this month the Financial Services Authority, the UK’s financial markets regulator, issued a 100-page paper expressing its fears about financial sector debt, especially in the red hot ‘private equity’ or corporate buyout sector.

Some private sector forecasters, investmen bankers Goldman Sachs amongst them, are projecting a 4% policy rate for the ECB by the middle of next year.

UNICE may get the pause it wants, but, unless global imbalances destabilise the world economy, the pause may not last very long.

Exchange rates rarely feature in formal economic forecasts. They are too unpredictable. But this does not mean that the small print on the final page of the autumn economic outlook from UNICE, the European employers’ group, should be ignored.