Where Mr Greenspan goes, must the ECB always follow? It ain’t necessarily so

Date: 18/01/01

When the US Federal Reserve chairman slashed interest rates earlier this month, many market analysts predicted that the European Central Bank would quickly follow suit. Don't count on it, ECB board member Matti Vanhala tells Tim Jones

THE European Central Bank has had a baptism of fire.

Having spent the first two years of its life coping with the inflationary impact and image problem of a plunging euro, the ECB starts the new year with the opposite predicament: a stalled US economy that just might tip the world into recession.

It is a time for calm heads, says Matti Vanhala, who as governor of the Bank of Finland sits on the ECB's 18-member governing council.

The 53-year-old economist knows only too well that members of his profession have a tendency to hunt in packs. The same gurus who predicted new highs for US stocks early last year are now outbidding each other with gloom scenarios as Wall Street's technology share index plummets.

"Market psychology is volatile," says Vanhala. "In asset markets, these corrections can seem drastic at times. Quite a few people have written too much drama into this. That's understandable but it's not the same thing as macroeconomics."

Vanhala spent the late 1960s and early 70s working as an economist, first at the Finnish finance ministry and then at the central bank, before heading the Bank of Finland's international department and representing his country at the International Monetary Fund in Washington from 1977 to 1980. In 1998, he was elevated to the governorship after his predecessor Sirkka Hämäläinen was tapped for the executive board of the ECB.

His reputation as a 'hawk' on the ECB council mirrors that of 'iron lady' Hämäläinen - a status confirmed by his caution against lowering euro-zone interest rates to offset a potential recessionary tidal wave heading across the Atlantic.

When US Federal Reserve chairman Alan Greenspan slashed interest rates earlier this month, investors assumed that the ECB would follow market sentiment and lop three-quarters of a point off euro-zone interest rates, bringing them down to 4%, by September.

Vanhala is bemused. "I find myself sceptical with regard to market sentiment," he says. "It is volatile, and when market people and portfolio economists talk about what they think will be the correct stance of monetary policy, they are influenced by those same portfolios. We shouldn't take guidance from something so volatile although it's understandable you'd think like that if you were sitting on a major bond position."

When interest rates rise, the value of bonds tends to fall so buyers can receive the same income from their fixed return. As a result, bondholders prefer low interest rates.

Market-watchers who expect the ECB to cut rates now in response to a US slowdown should remember two things, says Vanhala: first, that everyone knew something like this was coming so the bank has already taken it into account to some extent; and second, that evidence of an outright US recession is very sketchy.

US consumer spending seems to have slowed, middle-sized companies are finding it harder to raise capital and manufacturing activity has dipped to a nine-year low.

Americans have been hit hard by the fall in stock prices, which have underpinned their spending binges. In November, the US spent 0.8% more than it earned for the first time in history while the average American credit card carries €8,000 in debt.

"You've got to remember that this hasn't come out of the blue for us," Vanhala says. "Every forecaster was talking through the summer, autumn and winter about the probability that the US economy was going to slow down so we have taken a lot of this into account already. It is a slowdown and correction that all macro-economic forecasters thought was necessary to get growth back onto a sustainable track. Hopefully, we are seeing precisely what we asked for. An asset price correction that looks drastic might not necessarily herald anything so drastic in the real economy."

Vanhala echoes the view of Bank of England Governor Eddie George, who chaired a discussion among the world's 11 leading central bankers last week.

"I agree with the way he put it: that the year 2001 taken as a whole will probably show that it was a 'soft landing' in the US," says Vanhala. He will not be drawn as to whether this means the US will go through a technical recession - two successive quarters of falling national income - in the first six months of the year.

But he is convinced that, whatever comes, most EU countries will be much better prepared for the onslaught. "I think a lot of people in the euro area haven't got used to the fact that we live in a single area, meaning we're not as susceptible to external pressures as we were. Obviously, the US is a huge economy but nobody is talking about a radical cut in our expectation that growth in the euro area will be around 3% this year and next."

Signs of weakening domestic demand and confidence in Germany have not dampened the ECB's anti-inflationary zeal yet. Vanhala describes data and survey evidence coming out of Germany as "interesting and maybe indicating weakening inflationary expectations but this is only one piece of the puzzle. At the moment, it doesn't lead us to change the overall forecast for the euro area".

All this means that the ECB cannot afford to take its eye off the inflationary ball, despite the latest evidence coming out of France, Germany and Italy in December that consumer price inflation will brake sharply from November's seven-year peak of 2.9%. 'Core' inflation, or the rising price level once petrol and other volatile indicators are stripped out, is still on the increase and wage demands may be accelerating as two German unions demanded a pay hike of 5.5% for the 470,000 employees working in the banking industry last weekend.

Vanhala still sees "big upside risks" to the ECB's mandated target of 'price stability', defined as keeping annual euro-zone inflation between 0% and 2%. In a statement released last month, the ECB governing council stressed continuing "caution" about these "upside risks".

"I stand by the December ECB statement," says Vanhala. "Keeping inflation 'below 2%' doesn't mean 'inflation at 2%'. I am personally afraid that the longer people see inflation rates of 2%, it gets into their frames of reference and it changes expectations. With the oil price we saw and the euro exchange rate we saw, it's not unreasonable to worry about 'second-round effects' and not just on wages but also in the pricing behavior of companies."

Inflation does not take hold in an economy until 'second-round effects' begin - that is, when wage negotiators seek compen-sation for rising prices in their members' pay packets or firms pass on their higher input costs by hiking factory-gate prices.

In the meantime, Vanhala is holding his ground. "For the moment, the ECB's interest rate policy is correct," he says. "The ECB is running eurozone monetary policy and not US monetary policy."

When the US Federal Reserve chairman slashed interest rates earlier this month, many market analysts predicted that the European Central Bank would quickly follow suit. Don't count on it, says ECB board member Matti Vanhala.