Shadow Council Minority Vote: The Case for Unchanged ECB Rates

I propose to maintain official interest rates at their current level, for three reasons.
  • Joachim Fels, Morgan Stanley Chief Economist

First, most available forecasts suggest that, based on the current level of interest rates, inflation will average some 1.5-2 % over the next 12-18 months. In other words, the current stance of monetary policy appears to be consistent with a widely agreed definition of price stability - so why change it? Lowering rates would only be appropriate if the risks to this inflation projection were heavily skewed to the downside.
While there are some downside risks to prices related to the weak global and domestic economic environment, there is also a non-negligible risk that euro area inflation will turn out to be more sticky than expected yet again. The experience of the last several years, when most forecasters systematically underestimated inflation suggests caution, in my view.

Second, a reduction in interest rates now risks fuelling the excessive growth of monetary aggregates further. While excess money supply growth need not lead to higher consumer price inflation in the future, it risks pumping up an asset price bubble at some stage, which could have de-stabilising effects on the real economy in the future.
Given the experience with inflating and bursting asset bubbles in the last several years, monetary policy should try to reign in excess money and credit growth at an early stage. The possible short-run output costs of such a policy by far outweigh the potential future output losses in the aftermath of bursting asset bubbles.

Third, by cutting interest rates now, the ECB risks being seen as sanctioning imprudent past behaviour by other economic agents. Fiscal policies have been lax in several countries and the recent promises of fiscal consolidation are not fully credible. Various governments have resisted a more decisive deregulation of product and labour markets.
Wage growth has accelerated during 2001 and the first half of this year, despite the economic slowdown, and many companies have used the occasion of the euro cash introduction to push through hefty price increases. These actions combined have led to an unfavourable mix of higher inflation and slower real economic growth.
If the ECB cuts interest rates today, it will create incentives to repeat similar behaviour tomorrow. This would result in a lower central bank reputation and thus in higher inflation and interest rates in the future.