ECB’s U-turn cannot repair the political damage done

Only three months after its last rate hike, the ECB has yesterday prepared verbally for a sharp turnaround.  In contrast to former press conferences, President Jean-Claude Trichet stated that it is now clear that “economic activity in the euro area is weakening, with contracting domestic demand and tighter financing conditions.” According to him, “upside risks to price stability have diminished somewhat”, even if “they have not disappeared”. Importantly, the phrase that the “current monetary stance will contribute to achieving our objective” has been missing from the statements. Most observers read these changes in wording as a signal for an imminent rate cut, possibly as early as November with more cuts following until next spring (see for a good analysis Aurelio Maccario on RGE monitor).

From an economic perspective, it is good that finally the ECB is facing reality and that it is reacting to the violent downturn in the euro-area. A rate cut might not only lower the financing burden of households and companies in the euro-area at a time when signs of a credit crunch are emerging, it might also help to lead to a depreciation of the euro which could act as a welcome dose of oxygen for the struggling European export industry.

However, one can ask oneself why the hawks got their way only twelve weeks ago. Of course, the recent worsening of the financial crisis has surely contributed to the ECB’s decision, but already in July, it was clear that the euro-area was heading for a nasty downturn and that price pressure would quickly diminish (see our analysis here and here and our criticism of the ECB’s decision here). Nevertheless, the ECB increased interest rates and arguably thus made the downturn worse. The cut now runs the danger that the ECB will quickly find itself behind the curve, much as it was after the downturn after the bursting of the dotcom bubble.

Moreover, from a political perspective, the harm is already done even if the ECB retreats now: The euro-area is facing its first recession since the introduction of the euro and the ECB has increased interest rates at a point when the economy was already evidently on the verge of recession. Independence of central banks is a good think as we know from economic theory, but if the independent monetary policy makers make serious policy mistakes, it will become harder to explain this to the general public. A good guess is that after the dust settles from the crisis, we will see that the ECB this summer has not only hurt the euro-area’s economy, but mainly its own standing and reputation.

2 Responses to "ECB’s U-turn cannot repair the political damage done"

  1. Anonymous   October 5, 2008 at 5:16 am

    us cut interest rate and are in a worst position so …

  2. MDM   October 5, 2008 at 2:36 pm

    I totally agrre with you. ECB has comitted the same mistake as the FED in 29, by raising interest rates. The problem has always been deflation, and the ECB worrying about inflation…Well now we have Merkel guarranty on all german deposits…ECB should not wait and should bring down rates with the FED in a concerted action… we are heading for disaster…MDM