[DEBATE] : Not Following in the Fed's Footsteps?
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Sat Jan 26 01:43:48 GMT 2008
Economic Focus -- From Action Economics January 25, 2008, 4:01PM EST
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Not Following in the Fed's Footsteps?
ECB officials show no signs of implementing rate cuts at the next
policy meeting—and insist Europe can weather a financial downturn in
by Natascha Gewaltig
The European Central Bank (ECB) has declined to comment on the Fed
emergency move on Jan. 22, despite mounting speculation about an ECB
rate cut at the next meeting. Euro zone officials are clinging to
their hawkish inflation stance, though the markets have stopped
listening to the ECB's rhetoric. We do expect a shift to a less
hawkish stance at the meeting that would introduce the option of rate
cuts in the future.
The sell-off in stock markets earlier this week was accompanied by a
flurry of comments from ECB officials as well as politicians. ECB
Executive Board member Juergen Stark and Jose Gonzalez-Paramo, as well
as EU Commissioner Joaquin Almunia, indicated that stock markets may
be overreacting. Stark said one should not dramatize the market
correction and that current developments are "a necessary correction
of excesses of the past". Almunia stressed that one should not
overreact, and that U.S. imbalances are the "root cause" of the
Almunia spoke after a meeting of European Finance Ministers, which
indicates that he was representing the majority view of European
governments. He said the EU is "well prepared to weather" the turmoil
and stressed that EU fundamentals are sound. Meanwhile, Germany's
Thomas Mirow said market losses are unlikely to affect the economy,
and that the market turmoil is the U.S.'s responsibility. The EU still
sees growth close to potential, even though Almunia indicated that
growth rates are likely to fall short of last year's projections.
No Need for Change
Equally, ECB officials continued to stress that the main scenario is
for growth around potential, and Bundesbank President Axel Weber said
that he does not see the need for a change in the ECB's stance. Stark
said that "the situation today is different from that at the start of
the decade, when we also saw a clear slowing of economic growth" and
repeated that "in the whole euro area the fundamental economic data
are good." He pointed to favorable company profitability and stressed
that households are better off than in other areas, where they are
With growth still seen around potential, officials continue to stress
that the ECB's main mandate is to secure price stability. Stark
repeated that the ECB is closely monitoring developments and would
react accordingly. Weber said the ECB has zero tolerance with regard
to second round effects and firming inflation trends. And President
Jean-Claude Trichet said on Jan. 22 that "particularly in demanding
times of significant market correction and turbulences, it is the
responsibility of the central bank to solidly anchor inflation
expectations to avoid additional volatility." This was in line with
Vice-President Lukas Papademos, who said that "at this juncture it is
more important than ever that central banks continue to pursue their
primary objective of price stability."
Weber followed this up on Jan. 23 with remarks stressing that ECB
rates remain accommodative rather than restrictive, that the ECB
should not "signal any loosening," and that markets may be pricing in
"certain wishful thinking" regarding rates. However, while all this
still sounds hawkish, with no sign that the ECB has abandoned its
tightening bias, it seems almost impossible to believe that the ECB
would deliver a rate hike in the current situation. True, inflation is
running above 2%, but even Weber sees it gradually coming down toward
the end of the year, and the central bank's hawkish rhetoric seems
mainly designed to prevent high wage demands and second round effects.
This week's stock market losses, coupled with the public talking about
a slowdown in growth and the possibility of a recession, may in fact
make it less likely that unions will be able to secure large wage
deals, as workers will start to worry more about job losses than wage
gains. This should help the central bank to stay put even though
inflation is likely to overshoot the ECB's upper limit of 2% for most
of this year.
So, what about a rate cut at the next meeting? At the last council
meeting, the ECB did not even discuss the possibility of a cut and
only considered a hike, which indicates how far the central bank has
to go before rate cuts appear on the agenda. So far, officials still
seem hopeful that the euro zone can partially decouple from the U.S.
and sustain relatively robust growth.
This hope is not only based on the assumption that emerging markets
will partly compensate for a possible slowdown in the U.S. but also on
the hope that European housing markets will not see a crash similar to
the one in the U.S. The recent episode confirms once again that
financial market crisis tends to be triggered by house price crashes.
European banks may have suffered from their involvement in the U.S.
subprime crisis and will also feel the pressure from stock market
corrections but have so far escaped a crisis on the domestic property
Irish housing prices may have turned down, but Ireland itself is too
small to set the trend for the euro zone as a whole. Germany, the
largest euro zone country, avoided the housing boom in the first
place. France, the second largest, has experienced a slowdown. But at
5.6% annual growth in the third quarter, French house price inflation
still remains robust, and there is no sign of a crash. So far it looks
as if the normalization of the French housing market is gradual and
The country that seemed mostly at risk of a sharp correction was
Spain, the euro zone's fourth largest economy. Spanish house prices
have more than tripled in the past 10 years. At the same time, the
house price to income ratio in Spain has doubled in 10 years. The OECD
warned previously that house prices are overvalued by as much as 30%.
So far, however, the correction seems to be gradual and contained.
House price inflation has come down successively, but at 4.8% annual
growth in the fourth quarter, also remains relatively robust.
The Key Is Reform
Since there is no sign of a serious housing crash, the euro zone
financial system appears in position to weather the storm. ECB
officials also stress that reform efforts, and not cheaper credit,
will be needed to boost European growth. In contrast to the U.S., the
euro zone economy has been characterized by a marked slowdown in
productivity growth over the past decade. An article in the ECB's
latest monthly report points out that euro zone productivity growth
since mid-1990 has decelerated to an average rate of just 1.3%, which
is around 1.4 percentage points less than over the 1974-94 period. In
the U.S., on the other hand, the rate of productivity growth
accelerated to 1.9% on average, from an average of 1.4% over the past
The stronger productivity growth in the U.S. was a driving factor
behind higher growth compared with the euro zone's. U.S. growth
accelerated to 3.1% on average between 1995 and 2006, compared with
just 2.1% in the euro zone. This was only partially due to information
& communication technologies (ICT), with the largest discrepancy
between overall labor productivity and growth most apparent in the
more traditional ICT using sectors. It seems European companies have
not exploited the benefits of new technologies to the same extent as
in the U.S.
Over the 1995-2006 period compared with the previous 15 years, euro
area labor productivity growth fell in most non-ICT related sectors,
and especially in market services, including distribution, financial,
and business services. Yet, at the same time, it accelerated in the
U.S. This could indicate there is still potential to boost
productivity growth in the euro zone, provided governments press ahead
with reforms designed to create an entrepreneurial-friendly
environment, boost competition, and foster market integration across
the euro zone.
Clearly, these are objectives that will not have an immediate impact
on the economic situation. However, latest confidence data, including
the manufacturing PMI and Ifo, came in better than expected. And as
long as growth remains around potential, and interest rates are seen
around neutral, the hawks at the ECB will argue that lowering rates in
order to boost growth would only lead to an unsustainable boom-bust
cycle. They may even point to developments on the U.S. housing market
to support their arguments.
Nevertheless, comments indicate that at least national central bank
heads are getting increasingly nervous about the growth outlook. In
this environment, threats of a rate hike are looking out of place,
even though stock markets have recovered, and we would expect a
softening of the rhetoric at the next meeting. If the ECB effectively
moves to a neutral stance, this would leave the door open for cuts if
the euro zone economy turns out to be less immune to the U.S. slowdown
Gewaltig is director of European economics for Action Economics .
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