With this week’s ECB’s decision all but official, a more important question looms: what’s next? The ECB is a bank whose primary focus — witnessed in both its charter and its past actions — is price stability. Despite poor economic performance in recent months, the ECB essentially has to raise rates this week, as the Euro-Zone’s current inflation level is double the target of 2%. While President Trichet and his peers may pray that a single, small hike will be enough to curb rising inflation, the more likely scenario is that the policy move will not have a huge effect. So, the question remains: what’s next?
What’s next is a big decision. The age old debate (or as old as central banks have existed) between pursuing policies that facilitate growth or inflation is front and center in many prominent economies around the globe, and Europe is no exception. Rising energy costs have not helped the problem, leading some analysts to publically worry about stagflation rearing its ugly head. In a perfect world, high growth rates allow central banks to raise rates in the never-ending war on inflation (e.g. Australia). However, growth is unquestionably slowing all throughout Europe, and many fear that a rate hike could severely impact many of the smaller economies in the Euro-Zone.
In the long-run, Trichet (or whoever is in charge of the ECB in the future) has no choice; the ECB must focus on price stability first and foremost. However, in the next six months, what the ECB will do is anybody’s guess. One popular school of thought is that the ECB will employ a wait-and-see attitude; they will raise rates now and then observe the resulting economic data for a few months. Others feel that the ECB’s mandated focus on inflation will lead to a series of hikes, regardless of the costs. For many years, West Germany’s Bundesbank produced astounding economic prosperity, a result that many attributed to the Bank’s dedication to price stability. The ECB is a descendent of the Bundesbank, and so in my mind, I think that the ECB will not be done raising rates for the year after this week.
Of course, they could shock the world and not raise rates. You never know what will happen in the world of foreign exchange…
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USD ISM Prices Paid (Jun)