At the end of the European Central Bank’s monthly monetary policy meeting on November 3 2005 the bank’s president, Jean-Claude Trichet, described the existing policy stance – which had kept the ECB’s key refinancing rate unchanged at 2% since June 2003 – as “appropriate”. Yet at a conference barely two weeks later, on November 18, and again to a committee of the European Parliament on November 21, Trichet publicly declared that he felt the ECB was now ready to raise its interest rates “moderately”. This came about on December 1, when the refinancing rate was raised by a meagre 25 basis points.
What was it that caused the ECB president to give such a clear signal to the markets that rates would rise, so soon after a meeting at which the ECB’s governing council had decided that the existing level of interest rates was still appropriate? If the need for monetary tightening had suddenly become so pressing, why such a modest increase of 25bp, to 2.25%? And what did this imply for the future course of monetary policy and interest rates in the eurozone?
It is now apparent that the governing council had been unable to reach agreement on a rate rise at its November 3 meeting but the debate had been finely balanced. On the one hand, risks to price stability had been accumulating for some time. Since January 2005, the headline inflation rate had exceeded the ECB’s medium-term “price stability” objective of “close to but below 2%” and had edged down only slightly, from 2.6% to 2.5%, in October. Furthermore, growth of the broad money supply (M3), driven by its most liquid components (M1) and persistently low real interest rates, had been accelerating over the previous 15 months to an annual rate almost double the 4.5% that the ECB uses as its yardstick for price stability. Since June, there had also been signs of a gradual upward creep in inflation expectations and the exchange rate had resumed its downward drift.
| Exchange Rates and Real Interest Rates (Monthly averages) |
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| Growth of M3 and Bank Loans to Private Sector |
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| Inflation in the Euro Area |
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| Source: Ecowin/Eurozone Advisors |
On the other hand, with core inflation (taking out unprocessed food and energy prices) running at around 1.5%, there was still little evidence that higher energy prices were feeding through into other domestic costs and prices. At the same time, other economic indicators were giving no clear signals that growth in the eurozone economy was strengthening, let alone that demand pressures might be starting to emerge.
What then had happened between November 3 and 18 to prompt Trichet to announce suddenly that the governing council was about to change tack? On November 17, the governing council had its regular mid-month meeting, at which matters other than monetary policy are usually discussed. On this occasion, though, the hung debate of November 3 was reopened.
Few new economic data had appeared in the meantime and most of that did little to alter the picture of uncomfortably high headline inflation and still fragile consumer demand and industrial output. One new figure, however, stood out: gross domestic product in real terms, which had grown by only 0.3% in the second quarter of 2005, was estimated to have jumped by 0.6% in the third quarter, although this still left real GDP only 1.5% higher than a year earlier and hardly provided conclusive evidence that a strong and sustained recovery of the eurozone economy was at last under way.
At least as important, the governing council would have had an early sight of the ECB’s new projections of GDP growth and inflation in 2006 and (for the first time) 2007, which were to be presented in full at its December 1 meeting. These showed real GDP growing by 1.9% (a rate regarded by ECB staff as the upper limit of the eurozone’s short-term growth potential) in both 2006 and 2007, and inflation slowing only gradually, from 2.2% in 2005 to 2.1% in 2006 and 2% in 2007.
The governing council might also have been given some preliminary indication of the latest monetary data, which were scheduled for publication at the end of November. We now know that these showed that the growth of M3 in October, although slowing a little, was still rapid and that bank lending to the private sector continued to accelerate. This, together with the prospect of sustained economic growth and stubborn inflation, will have strengthened the case for raising rates, emboldening Trichet – anxious not to be seen to be caving in to political pressure to keep policy loose – to commit the ECB publicly to a rate rise and so raise the stakes in the governing council’s internal debate. It was only after further discussion at the council’s next meeting, on December 1, against a background of fresh data showing a slight dent in economic sentiment and an easing of the headline inflation rate to 2.4%, that a consensus could be found for a rise of 25bp. This Trichet, has admitted, was a compromise between those members who wanted a 50bp increase and those who argued that any increase was premature.
This raises the question whether 25bp will prove to have been enough to address effectively the concerns of those who wanted a bigger rate rise. Real interest rates remain very low in historical terms, as Trichet keeps pointing out, and are unlikely to dampen economic activity. By the same token, they are unlikely to do very much, either, to restrain monetary growth and the demand for credit. Trichet has described the ECB’s policy stance as still being accommodative but he has also said that the governing council was “not ex ante engaging in a series of interest rate increases”. He is unlikely to want to reopen in the very near future what has been a difficult debate in the governing council, but those who had argued for a 50bp rise will be looking for further economic evidence to back their case.