The European Central Bank. Haughty indifference, or masterly inactivity

Monetary policy in the euro area has been looser than critics think

TWICE a month the governing council of the European Central Bank (ECB) meets on the 36th floor of the Eurotower in Frankfurt. The lifts must be permanently out of order, leaving members so out of breath by the time they reach the boardroom that they can no longer think straight. What other explanation can there be for why the bank has left interest rates stuck at 2% for no less than 25 months?

The bank's many critics claim that the euro area's economies are being choked by an excessively tight monetary policy, and that the case for lower interest rates is overwhelming. It has become conventional wisdom that the ECB is peopled by inflation nutters who couldn't care less about economic growth. Yet a look at the facts reveals that by most measures the ECB's policy has not been overly tight.

It is true that in 2001-03, after stockmarkets slumped, the ECB cut interest rates by less than America's Federal Reserve did, but that was partly because American rates started off at a much higher level, and America's inflation rate fell more sharply. Real interest rates in the euro area have been negative or near zero for most of the past two years, their lowest for more than 25 years.

This suggests that policy is fairly loose, as does the growth in the M3 measure of money supply, which has exceeded the ECB's desired range for four years running. The Fed may think that money no longer matters, but the ECB worries that this overhang of liquidity will eventually stimulate inflation or asset-price bubbles. The ECB's critics like to make fun of the prominence it gives to this measure, but, as the Bank for International Settlements argued recently, keeping an eye on money and credit provides a useful check against the build-up of financial excesses.

A widely used test of the tightness of monetary policy is the Taylor rule, which calculates the “correct” interest rate according to the amount of spare capacity in the economy and the deviation of inflation from its desired target. What does it say about interest rates in the euro area? Calculations by David Mackie, of J.P. Morgan, show that virtually throughout the past six years, interest rates in the euro area have been lower than a Taylor rule would have prescribed, refuting the popular wisdom that the ECB cares less about growth than does the Fed.

But even if the ECB has not, on average, been as tight as many people think, it has changed interest rates less often than the Fed has, giving the impression of paralysis. One reason why the ECB is less active is that estimates of the output gap in the euro area - the amount of slack in the economy - are subject to much bigger revisions than in America. In late 2000, the OECD reckoned that GDP in the euro area was 0.3% below potential in that year. Now it thinks GDP was 1.6% above potential.

The correct interest rate depends partly on the inflation target; thus another common criticism of the ECB is that its target of “below, but close to, 2%” is too low. Some say that if, like the Bank of England, the ECB had a symmetrical inflation target centred on 2%, it would have been able to loosen the monetary reins. Some go on to argue that the ECB's inflation target should be higher than the Bank of England's, to take account of divergences in inflation rates among the euro area's 12 members and so guard against the risk of deflation in an individual country. Although the ECB's inflation target would be better expressed as a range of 1-3%, in practice it might not make much difference. The ECB has behaved as if 2% were the midpoint not the ceiling: during the past five years inflation has been below 2% in only nine months.

Furthermore, the euro area's official inflation rate may well understate inflation, because the harmonised index of consumer prices, which the ECB tracks, excludes the housing costs of owner-occupiers, a large slice of the cost of living. Calculations by the OECD suggest that if such costs were added in, average inflation in the euro area last year would have been 2.7%, not the published 2.1%.

Monetary conditions in any economy depend not only on short-term interest rates, but also on the exchange rate and long-term bond yields. The ECB probably made a mistake in not cutting interest rates last year to offset the impact of the rising euro, which caused monetary conditions to tighten just as growth stumbled. However, the euro's trade-weighted value has fallen by 5% since the start of this year, taking it below its value when the single currency was launched in 1999.

Bond yields probably have a bigger effect on economic activity in the euro area than short-term interest rates. Over the past year, ten-year government bond yields have also fallen, from 4.3% to 3.2%. Julian Callow, an economist at Barclays Capital, reckons that the combined fall in the euro and long-term bond yields since the start of this year are equivalent (in terms of their impact on GDP) to a cut in short-term interest rates of around one percentage point.

Less compelling

The recent slide in the euro and bond yields may explain why the OECD, which argued that the case for a half-point interest-rate cut was “compelling” in its Economic Outlook in May, now seems more relaxed. In its annual survey of the euro area it appears relatively content if rates are held at 2%. But if the euro strengthens and economies remain weak, then the case for a rate cut will gain ground again.

The OECD admits that the ECB's task is made trickier by two obstacles. The first is the stickiness of inflation in the euro area as a result of a lack of competition, especially in services. Inflation falls more slowly in a downturn than in America, reducing the scope for the ECB to cut rates to support the economy. Structural reforms to strengthen competition and reduce price inertia would make monetary policy more effective.

The second obstacle is that monetary policy tends to be a less potent weapon in the euro area than in America or Britain. The transmission mechanism from interest rates to consumer spending is weaker, largely because of less developed and less competitive mortgage markets. In the euro area, it is much harder to turn capital gains into cash by borrowing more as home prices rise or to benefit from falling interest rates by refinancing fixed-rate mortgages, both of which have given a big boost to American household spending. Even though house prices in France, Italy and Spain have risen by more than in the United States, the wealth effect on consumer spending has been smaller. The solution lies not in cutting interest rates further, but in shaking up the over-regulated mortgage market.

The blame for the euro area's feeble growth rate lies mainly with an over-tight fiscal policy and structural rigidities. Adjusting for the economic cycle, fiscal policy has been much tighter in the euro area than in America or Britain, thanks to the stability and growth pact, which forced governments to raise taxes even during a downturn. Many countries are slowly trying to make their labour markets more flexible. The snag is that in the short run reforms that reduce job protection are more likely to depress consumer spending.

So could the ECB not cut interest rates further to cushion economies as reforms are carried out? With inflationary expectations now well anchored just below 2% and the core rate of inflation at 1.6%, there seems little danger of inflation surging out of control. However, the ECB argues that if the lowest real interest rates for a quarter of a century have failed to spur demand, then another half-point cut is unlikely to do the trick. In the next breath officials then add that lower interest rates would risk stoking up household-credit growth, which is already running alarmingly fast. The ECB cannot claim both that interest-rate cuts won't work and that they risk fuelling excessive borrowing.

Here lies the real vulnerability of the ECB: its public communication. Even if monetary policy is not stifling growth, the bank's language constantly gives the impression that policy needs to be tight to guard against the ever-present threat of inflation. If you keep telling people there is nothing you can do to boost growth, it is no wonder that they spend cautiously. It may not be interest rates that the bank urgently needs to change, but its tone.