TRICHET MUST NOW RAISE RATES AGAIN / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Trichet must now raise rates again

By Thomas Mayer

Published: April 7 2011 12:53

Jean-Claude Trichet, European Central Bank president, today confirmed what markets had been expecting: a 25 basis point rise in eurozone borrowing costs, to 1.25 per cent. Mr Trichet will now face criticism for raising rates too early. But the doves are wrong: a raise in rates could not have waited any longer, and more must now follow.


The economic case for returning rates to normal levels rests partly on the eurozone growth outlook. Following its 2009 slump the zone’s economy rebounded quickly in 2010, and is now set to grow next year at close to its (albeit significantly reduced) rate of potential, at between 1.5 and 2 per cent.

Yet while growth is solid, inflation surged to 2.6 per cent in March, in part reflecting higher prices for energy and food. It is likely to hover above this level for the rest of the year.


Add higher input prices and stronger wage growth in the more robust countries of the eurozone to this picture, and inflation is likely to average at least 2 per cent in 2012 as well. Equally, given factors like sticky wages and indirect tax increases, inflation in the weaker parts of the eurozone is unlikely to decline much either.

Dovish economists counter that a large “output gap”, meaning the difference between potential and actual gross domestic product, will stop these inflation forecasts being realised. But their case rests on shaky ground. Past experience has shown that it is impossible to develop reliable estimates of how big this gap might be, making it an unwise basis for policy decisions.


Other ECB critics argue that this is not the time to take risks. Why not wait and see whether growth indeed holds up, and inflation rises as predicted? But this view assumes that there is no cost for keeping rates at record low levels, other than perhaps a temporary overshoot of inflation.


In reality interest rates have a strong impact on investment decisions. Very low rates risk excessive increases in asset prices, and investments in projects with low returns. Then, when rates need to be raised eventually, asset prices collapse and the projects become unviable. As the financial crisis has demonstrated, the subsequent economic disruption is extremely painful.

Finally, quite apart from these economic considerations, there is a strong political case in support of Mr Trichet’s move. Many economists, including those at the ECB, have warned over and over again that the euro can only become a stable currency if governments ensure sound fiscal policies and flexible economies. So far many have failed to live up to their responsibility.


So by reacting to the real risk of inflation, the ECB is sending a clear message: they will stick to their mandate and refuse to let the governments off the hook by softening the euro. Now further moderate rate increases during the remainder of this year are needed to drive this message home.


The writer is chief economist at Deutsche Bank

Copyright The Financial Times Limited 2011.