Thursday, April 02, 2009

The Myth Of The Hawkish ECB

Today, the ECB decided to lower its refinancing rate to 1.25%, the lowest level ever. The cumulative 300 basis point cuts in the last 6 months is its most aggressive easing ever. Yet it is still under constant attack from certain pundits who claim they should have been even more aggressive, pointing to central banks like the Federal Reserve, the Bank of England and the Swiss National Bank that have lowered short-term rates to near zero and at the same time initiated various "quantitative easing" schemes.

It is true that compared to many other central banks, the ECB has been relatively moderate in its inflating. But that only reflects how inflationist these other central banks have been-not any kind of deflationist bent from the ECB.

-With regard to interest rates, the current refinancing rate is the lowest ever in the history of the ECB and it has been reduced at a much faster pace than anytime before in the history of the ECB. Moreover, short-term rates are actually a lot lower than the refinancing rate. Money market rates are closer linked to the ECB overnight deposit rate, which is 1 percentage point lower. So for many of the most important short-term rates, the ECB is already pursuing a Zero Interest Rate Policy.

-With regard to money supply, after reaching a low of 0.2% in August 2008, the 12 month growth rate of M1 has accelerated sharply, to 6.3% in February 2009 (Note that these numbers exclude the effects of Slovakia's adoption of the euro in January 2009, and the similar inclusion of Cyprus and Malta in January 2008), mostly as a result of the aforementioned aggressive interest rate cuts. Note also that this 6.3% gain has come entirely in the last 6 months. The 6 month growth rate is as high as 13.3%, compared to a slight contraction during the 6 months ending August 2008. The 3 month growth rate is even higher, 15.7%.

-With regard to price inflation, it is true that it has fallen quite a bit (To 0.6% in March). The 12 month rate might even fall further in the coming months. But price inflation is not a leading indicator, it is usually a lagging and at best a coincident indicator. Today's relatively low price inflation is the lagged effect of the stagnant money supply the euro area had early in 2008, as well as the effect of the sharp drop in global commodity prices between July and November 2008.

Thus, the characterization of the ECB as "deflationist" or "hard money" is simply not true-at least not in the absolute sense of the word.


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