In an effort to fight inflation, the European Central Bank hiked their benchmark rates for the 15-country Euro zone by .25% today as expected, but implied that this is not the beginning of a campaign: “On the basis of our current assessment, the monetary policy stance following today’s decision will contribute to achieving our objective.” According to their statement, there were 3 rates affected, with the first being the equivalent of our overnight bank-to-bank Fed Funds Rate, and the second being the equivalent of our 1-28 day Fed-to-bank Discount Rate:
1. The minimum bid rate on the main refinancing operations of the Eurosystem will be increased by 25 basis points to 4.25%, starting from the operation to be settled on 9 July 2008.
2.The interest rate on the marginal lending facility will be increased by 25 basis points to 5.25%, with effect from 9 July 2008.
3.The interest rate on the deposit facility will be increased by 25 basis points to 3.25%, with effect from 9 July 2008.
ECB head Jean-Claude Trichet has been worried about inflation in Europe in recent months as the rate stands at 4% versus a 1-2% target range. Note: this is overall inflation, not core inflation which excludes food and energy, only the US puts so much emphasis on the core number. The ECB has a single mandate which is to control inflation. The Fed has a dual mandate which is to control inflation and stimulate growth. In a global economy, it seems silly that a major central bank would not officially be responsible for both sides of the economic cycle, but that’s how the mandates are spelled out now. At least Trichet did acknowledge the credit crunch and its potential negative impact on economic growth, but held that inflation is the bigger threat:
HICP inflation rates have continued to rise significantly since the autumn of last year. They are expected to remain well above the level consistent with price stability for a more protracted period than previously thought … Moreover, continued very vigorous money and credit growth and the absence thus far of significant constraints on bank loan supply in a context of ongoing financial market tensions confirm our assessment of upside risks to price stability over the medium term … At the same time, while the latest data confirm the expected weakening of real GDP growth in mid-2008 after exceptionally strong growth in the first quarter, the economic fundamentals of the euro area are sound. Against this background and in full accordance with our mandate, we emphasise that maintaining price stability in the medium term is our primary objective.
Other notable excerpts from the statement are below:
High Employment Vs Food/Energy Prices
Employment rates and labour force participation have increased significantly in recent years, and unemployment rates have fallen to levels not seen for 25 years. However, these developments, which support household disposable income and consumption, are unlikely to fully compensate the loss of purchasing power caused by higher energy and food prices.
Actual Inflation Rates
With regard to price developments, annual HICP inflation (Harmonized Index of Consumer Prices) has remained well above the level consistent with price stability since last autumn, reaching 3.7% in May 2008 and – according to Eurostat’s flash estimate – 4.0% in June. This worrying level of inflation rates results largely from sharp increases in energy and food prices at the global level in recent months.
Looking ahead, on the basis of current futures prices for these commodities, the annual HICP (Harmonized Index of Consumer Prices) inflation rate is likely to remain well above 2% for quite some time, moderating only gradually in 2009. We are thus currently experiencing a protracted period of high annual rates of inflation, which is likely to be more persistent than anticipated some months ago.
Global Inflation Requires Fundamental Behavior Change
The shift in relative prices and the related transfer of income from commodity-importing countries to commodity-exporting countries have to be accepted. They require a change in the behaviour of companies and households. Therefore, broadly based second-round effects stemming from the impact of higher energy and food prices on price and wage-setting behaviour must be avoided. All parties concerned, in both the private and the public sector, must meet their responsibilities in this regard. In this context, the Governing Council is concerned about the existence of schemes in which nominal wages are indexed to consumer prices. Such schemes involve the risk of upward shocks in inflation leading to a wage-price spiral, which would be detrimental to employment and competitiveness in the countries concerned. The Governing Council therefore calls for such schemes to be avoided.
The monetary analysis confirms the prevailing upside risks to price stability at medium to longer-term horizons. In line with our monetary policy strategy, we take the view that the sustained underlying strength of monetary and credit expansion in the euro area over the past few years has created upside risks to price stability. Over recent quarters, these risks appear to have become manifest as inflation has trended upwards. Against this background, the continued strength of monetary dynamics represents an important signal of the risks to price stability over the medium term that we have been addressing through our actions since end-2005, including today’s move.
More specifically, annual M3 growth has remained very vigorous in recent months, supported by the continued strong growth of MFI loans to the private sector. Although annual M3 growth of still above 10% overstates the underlying pace of monetary expansion, owing to the impact of the flat yield curve and other temporary factors, nonetheless, even after taking such effects into account, a broad-based assessment of the latest data confirms that the underlying rate of money and credit growth remains strong.
Euro Zone Not Feeling Credit Crunch As Intensely
Not least in the face of the ongoing tensions in financial markets, the monetary analysis helps to support the necessary medium-term orientation of monetary policy by focusing attention on the upside risks to price stability prevailing at medium to longer horizons. Moreover, a thorough assessment of the money and credit data has provided an important insight into bank behaviour and financing conditions. In particular, the strength, maturity and sectoral composition of bank borrowing suggest that, at the level of the euro area as a whole, the availability of bank credit has, as yet, not been significantly affected by the tensions.
Fiscal Policy In Euro Zone
Regarding fiscal policy, budgetary consolidation targets are at risk in a number of euro area countries. Moreover, the risk of countries’ budget deficits coming close to or even exceeding the 3% of GDP reference value has increased. The Governing Council therefore reiterates its strong support for a rigorous implementation of euro area governments’ 2008 budgets and a prudent design of fiscal policy plans for 2009, in line with the agreement in the Eurogroup in May 2008. Achieving and maintaining sound structural fiscal positions is essential to ensure the sustainability of public finances as well as to create scope for the free working of automatic stabilisers in all euro area countries and thereby contribute to the smoothing of cyclical fluctuations.