Monetary policy. Bratwurst and sushi

Why Europe's monetary policy needs to tighten and Japan's doesn't

EUROPE'S interest rates, stuck at 2% for 30 months, have not increased in more than five years. So the signal last week by Jean-Claude Trichet, president of the European Central Bank, that rates would rise at the bank's meeting on December 1st was shocking, especially as many condemn any talk of dearer money as imprudent and premature.

Many European politicians argue that a rise in rates could snuff out the euro area's economic recovery. The region is at last perking up, with average growth in the third quarter of 2.6% at an annual rate, but consumer spending remains fragile. Indeed, some commentators fret that a rise in interest rates - especially when Germany plans to raise value-added tax - risks repeating Japan's past policy mistakes, and will tip the euro area back into recession. This is what happened when Japan increased its consumption tax in 1997 before recovery was firmly underway. Then in August 2000, after the economy appeared to be recovering, the Bank of Japan (BoJ) raised interest rates by a quarter point, only to be forced to reverse policy abruptly when the economy again buckled.

Will the same happen in Europe? Fashionable though it is to compare the euro zone to Japan, their economies are no more alike than bratwurst and sushi. The euro area's inflation is running at 2.5%; when the BoJ raised interest rates in 2000, Japan was suffering from deflation (it still is). Even with zero interest rates, Japan's real rates were already positive before the BoJ pushed them higher. In contrast, the euro area has enjoyed negative real interest rates for most of the past two and a half years. In sharp contrast to Japan in 2000, the euro area's monetary policy is unusually loose. After all, both the money supply and bank credit are growing at an annual pace of more than 8%. In Japan in 2000, bank lending was contracting, along with property prices, unlike in Europe today.

Lost in translation

The euro has weakened this year and long-term bond yields have fallen, creating even easier monetary conditions. This makes a nonsense of the argument that the ECB's policies are choking demand. Nor is the ECB obsessed with defeating inflation: in only nine months during the past five years has inflation been below the bank's 2% ceiling. It is true that the core rate of inflation (excluding food and energy) is only 1.5%. But it is the headline rate that influences inflationary expectations. Moreover, both inflation measures exclude the housing costs of owner-occupiers, a large slice of the cost of living. Add them in and inflation would be higher.

Today's interest rate was set in 2003 when the ECB was worried about the risk of deflation. The risks now lie more on the upside. The neutral rate of interest (which neither stimulates nor restricts the economy) is around 4%, so a modest rise in rates would still leave policy expansionary - as it needs to be while there is still economic slack. But with stronger borrowing and demand, the ECB is right to want to nudge interest rates slowly back towards normal levels to prevent a build-up of excess liquidity, which could spur future inflation or asset-price bubbles. Relative to the strength of its economy, the ECB would indeed be starting to tighten policy sooner than America's Fed did when it first raised rates last year. But, arguably, the Fed left policy too loose for too long. By doing so, it inflated its housing bubble, which could pop next year with painful economic consequences.

If anybody needs to take heed of Japan's policy mistakes it is the Bank of Japan itself, which is also keen to end its zero-interest-rate policy. Japan's output has rebounded more strongly than that of the euro area over the past year, but prices are still falling, so growth in nominal GDP remains weaker. The official core rate of inflation could soon turn positive, but this measure includes oil prices which have risen sharply over the past year. Stripping out energy, Japan's inflation rate will stay negative for a while. The Bank of Japan should not even think about tightening policy until deflation is decisively beaten.

Japan has the highest real interest rates among the big three economies, the euro area the lowest. That is a good reason for different policy advice. Bratwurst and sushi don't mix.

Editorial outlines why Europe's monetary policy needs to tighten and Japan's doesn't.