The European Central Bank (ECB) is ten years old. During its first decade it had to deal with the technology bubble and its subsequent collapse, fears of global deflation, euro weakness and euro strength and the recent credit crisis. Arguably, it met these challenges successfully.
The Bank set itself the target of keeping inflation close to, but below 2 per cent. It has come very close to achieving this aim. Over the last decade inflation averaged exactly 2 per cent and was, for the most part, within 0.5 per cent of this level. Meanwhile, real GDP growth over the period averaged 2.25 per cent – in line with most estimates of its trend rate – and recession was avoided.
As the ECB’s leading figures will be well aware, however, there is no scope for complacency. The situation now facing the Bank is as serious as any that it faced over the last ten years.
The good news is that the additional liquidity it pumped into the financial system over the last six months appears to have stabilised money markets, which were threatening to seize up in the wake of the credit squeeze.
The bad news is that inflation pressures in the eurozone are greater than at any time since the early 1990s. The inflation rate in April was 3.3 per cent and, unless there is a sharp reversal in oil and food prices in coming months, it could well reach 4 per cent before the end of the year.
Although the ECB has not changed its key interest rate since last June, when it was raised to 4 per cent, it has been dismissive of the notion that interest rates should be cut. Despite falling business and consumer confidence, which are usually signs that economic growth is slowing, the Bank remains wholly focused on the inflation threat.
If wage inflation should start to rise in response to higher price inflation, the ECB would probably increase interest rates to make clear its continued commitment to the inflation target. In the short-term, this would be bad for economic growth and would do nothing for the Bank’s popularity. But it would be the right decision for the medium-term health of the eurozone economy.
Tony Dolphin, director of economics and asset allocation, Henderson Global Investors.
