The ECB should adopt a wait and see attitude for now. The economy is holding up well, the international outlook should be improving as a result of the massive policy actions in the US, the ECB's liquidity injections are well timed and, by extending the term, address the funding problems at least partially, and the risk of inflationary expectations becoming unmoored remains high. In this environment, there is no longer need for preemptive easing and thus the ECB can afford to wait and see. Should the economy weaken materially the ECB can cut rates, but should the economic outlook improve significantly then the ECB can think about hiking rates. With global monetary conditions very loose and global central performing LOLR actions, the downside risk to the global outlook has been greatly reduced.
As expected, headline inflation has increased again over the last month and there is no sign of a rapid turnaround on this front. With money supply and credit expansion continuing despite the sub prime crisis there is thus no reason to lower rates. Why not increase rates now? Monetary conditions are already tighter now than a few months ago because of the appreciation of the euro. Moreover, it is not yet clear whether the euro area economy will fully 'decouple' from the US. A significant slowdown seems to be under way in Europe as well and should have, over time, some dampening effect on prices. In a forward looking approach the dangers to price stability seem thus to be close to balance, but one has to admit that the news flow seems to be pushing the balance towards the area where the dangers to price stability become every more important.
As for last month, I do not see room for a change in the rate in the present circumstances. Indicators show that at global level expectations of a slowdown have been confirmed, although the depth of it is still unclear. In light of past episodes of international business cycle, the US deceleration may affect Europe with some delay. We may expect further bad news on the European Cycle. In the meanwhile, however, the cyclical conditions and the policy reaction in the US --- leading to a further drop in the dollar-euro exchange rate --- have arguably affected European countries differently, contributing to a decline in confidence in some countries, while others seem relatively unaffected. Overall inflation is still rising per effect of commodity and food prices. As I also stressed last month, the conditions in the financial markets are far from been back to normality, possibly requiring continuing liquidity support to the financial system.
I stick to my recommendation „no change” of interest rate at the moment. However, I propose to start preparing the market for a moderate rate cut in the near future, based on economic data signalling that growth in the Euro area in 2008 will be below potential which ultimately will also dampen inflation expectations.
My concern is that we are focussing too much on backward looking indicators. Yes, headline inflation is far too high, but this is the result of commodity price developments (not under our control) and of monetary policy decisions from about two years ago. Yes, the economy is slowing only gradually, but we may not have seen the full fall-out from the financial crisis yet (the same, incidently, may apply to credit growth). Looking forward, I regard it as highly likely that the financial crisis will slow growth not only in the US but also in Europe. So far, Europe has been able to benefit (or free-ride, if you want) from the rate cuts of the Fed - government bond yields have come down allowing a widening of credit spreads without dealing a very severe blow to credit costs of firms (see chart 27 of the ECB's March Bulletin). However, monetary policy divergence between the ECB on the one and the other G7 central banks on the other side is causing stress in the currency markets. Thus, the real effective exchange rate of the euro (broad country group, CPI-based) is now back to its level of early 1995, shortly after the Mexico ("Tequila") crisis of December 1994. Then, European growth dropped sharply as a result of the exchange rate appreciation. It would be unwise to expect the exchange rate to have no effect this time. The bottomline is: There is good reason to moderately reduce interest rates now in order to buy insurance against a future severe fall-out from the financial crisis (and lean against a further tightening of monetary conditions). This crisis is global in nature, and crisis management will be undermined if the ECB takes the opposite position to the Fed (especially when this position is based on backward looking indicators).
I think that there is a significant risk of a pronounced slowdown in activity that would more than offset some of the current inflationary pressures. Inflation may stay high for some time but wages have not responded and are unlikely to do so as growth decreases. I also think that the ECB's communication should be rebalanced to acknowledge in a clearer way the significant downside risks to growth.