Today ECB president Trichet pre-announced a rise in interest rates at next month’s ECB Council meeting, the second such rise since the crisis.
As I argued on the occasion of the first rise (here and here), the euro area needs higher interest rates like the proverbial hole in the head. The arguments made then have also not been affected by subsequent incoming data and remain valid.
A rise is not justified by inflationary fears. Core inflation remains well-anchored. First quarter growth did come in unexpectedly strong. But growth should be strong after a deep recession! And in any case what is decisive for monetary policy is growth prospects, and it is clear that the growth dynamic in Europe will weaken as global trade partners slow, fiscal austerity begins to bite and because of high commodity prices. The risks going forward are massively tilted to the downside. In particular the ongoing and unresolved euro area crisis could worsen at any moment.
I actually support the ECB’s line on rescheduling (i.e. defaulting on) soveriegn debt: if we had a sensible recovery strategy for the peripheral countries it would not be necessary. There is no economic case, in my view, for taking such a risk, which will also have longer-term costs in terms of future government debt financing. However, it is inconsistent for the ECB to take this line and, at the same time, raise interest rates, squeezing the peripheral economies and making it much harder for them to consolidate their public budgets, repair their banking systems and regain relative competitiveness within the euro area.
The ECB’s own projections (mid-point) have both growth and inflation at 1.7% next year. If they were actually to be achieved the former would certainly be too low to substantially reduce unemployment and the latter, I would argue, should also be higher.
Europe does not need slower real economic growth, lower inflation, upward pressure on the exchange rate and downward pressure on employment growth, nor higher costs for borrowers and greater risks for its financial sector. Yet these are the uncontroversial and well-understood consequences of higher central bank interest rates.