With European interest rates up 200 basis points since late 2005, and the euro near a record high, Sarkozy wants the ECB to stop raising rates now. ECB president Jean-Claude Trichet and the Governing Council strongly disagree. At the ECB press conference in early July, Trichet signalled at least one more rate hikeeither in September or October. Some Council members are known to support two more rate hikes before year-end.
What makes monetary policy tricky at this point is that the German economywhich has been Europes locomotivemay be reaching a turning point. Surveys of business and investor confidence have softened, and the so-called hard data has been mixed. Second quarter German GDP has stalled after a surprisingly strong first quarter. The jury is out, but there is reason to be concerned. The euro is at record levels, oil prices are surging and interest rates are expected to go higher. The euro-zone economy is not bulletproof though the hawks in the Governing Council often talk as if it were.
Just as last year when there was unwarranted growth pessimism in Europe, this year there is unwarranted growth euphoria. Many Germans are in denial that the cyclical upturn may be coming to an end. Were the Governing Council to miss the coming turn while blithely raising interest rates, they would be portrayed as drunken sailors on a rate-raising binge. The roar for greater political control over Europes central bank would be deafeningand not only from France.
The political costs for the ECB of making this type of mistake could be exorbitant. This is why the ECB must be very prudent as it considers whether to maintain the current pace of rate hikes, in which case it would raise rates by 25 basis points in September, or slow the pace down a bit, in which case the next rate hike would come in October at the earliest.
In the current political environment, the dangers to the ECB from outside political interference are much greater from raising rates too fast than too slowly. If it goes too slow, the ECB has earned sufficient credibility as an inflation fighter to make up for it in the future with little if any economic or political cost. But if it goes too fast, the political cost could be substantial and irreversible. Politicians will push for more control. But will the ECB see it this way As a matter of principle, the hawks refuse to consider the political costs of their actions. In earlier times, this was a harmless affectation. But it is an extremely dangerous attitude with people like Sarkozy watching so closely. There is more interest in Sarkozys populist ideas about currency intervention than is commonly realised.
Even the doves might support a rate hike in September to counter-act the charge that they are being bullied out of a September hike by Sarkozy. There is no doubt that Sarkozys attacks on the ECB are having a counter-productive effect in this regard. In the final analysis, whether the next rate increase comes in September, October or whenever, the data will determine how far the ECB goes with its rate hikes if the bank is savvy enough to keep the politicians at bay. But this is a big if. The fight is on between the two French titansTrichet and Sakozywith the fate of Europes central bank hanging in the balance.
Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University
Project Syndicate, 2007