Don’t Cry (or Cry Out) for the ECB

I would like to express some sympathy for the current predicament of the European Central Bank (ECB).  They will undoubtedly come in for a great deal of criticism in the weeks ahead, particularly following their refusal to move interest rates today – if our Baseline Scenario view continues to hold.

But you have to keep in mind that they, unlike the Fed, have a very explicit mandate focused on just one variable: inflation.  It is true that there is some scope for interpretation both broad and narrow.  The broad scope exists because, for example, if actual growth slows below what is called “potential growth” (a very elusive number), inflation will decline eventually.  So when you think about what inflation should be, you are really thinking about where growth is relative to potential – and this is what interest rates can affect (keep in mind all these effects are lagged, i.e., take between one and two years to work their way through the system).  And the narrow scope means there is some choice over exactly what inflation measure you aim for and whether you can look at other things (such as money supply).  This quickly slips into monetary theology and I’m not going there, at least today.

In any case, the ECB has a pretty clear mandate and it also has a board on which almost all countries that belong to the eurozone get to vote (there are now slightly more members than seats).  The management of the ECB comprises the best minds in the business, with impressive experience in the private sector, academia and central banking.

But the basic point comes down to this.  The ECB is in Frankfurt.  And the real deal is that it represents all that is great and good about post-1945 German monetary policy, with its emphasis on trampling on inflation at every opportunity.  This worked well for Germany for a long time and it might even be a good idea now (although I’m a bit skeptical).

The problem is that it is very unclear that this focus on fighting inflation will be appropriate for all eurozone countries.  Spain and Ireland are clearly slowing down.  The latest data, put out by the European Commission, points to recession in France and Italy.

But the ECB was given a job to do.  They have a clear mandate, and they are not supposed to be flexible (unlike the Fed).  And the German authorities are watching. The ECB will cut interest rates only when they see eurozone-wide recession definitely “in the data”.  Of course, by then it will be too late.  But they are really only doing their job.  And there is nothing in their job description about preventing the world from slipping into depression.