Jumping the Gun?

Two weeks ago, the European Central Bank (ECB) raised its benchmark interest rate from 1 percent to 1.25 percent, putting it at odds with its counterparts in the United States and Britain. This move has sparked a debate as to whether the ECB jumped the gun with the interest rate hike.

Before espousing either side of the argument, there are several important differences between the ECB and most central banks to keep in mind. First, the ECB has a single mandate, to promote price stability. Compare this to that of a dual mandate, which includes ensuring maximum employment, held by most central banks. Second, the ECB manages monetary policy for 17 different countries compared to a single country for most central banks. Finally, although all central banks seek to operate independently of their government, the ECB’s independence was enshrined in the treaties creating the euro and is a major focus of the bank’s leaders. In his memoir, The Age of Turbulence: Adventures in a New World, Alan Greenspan wrote he was afraid the political independence of the Federal Reserve was no longer set in stone.

In one camp are economists who argue the ECB is raising rates too early and that the higher interest rate will have negative consequences for peripheral countries such as Ireland and Portugal – whose government became the third to request a bailout and just a day prior to the rate increase. The economists say the rate increase could disrupt the fragile recovery and further hinder those countries’ ability to raise capital in the public markets. In a New York Times article, Michael Darda, chief economist at MKM Partners, said by responding to higher oil prices with interest rate increases, the ECB was making the same mistake as the Fed in the 1970s and 1980s. “The ultimate effect is that they are going to restrain inflation in Germany and France but will cause deflation in the periphery, which will cause austerity programs to fail,” Mr. Darda said. “This could very well spread into Spain and Italy.”

In the other camp are economists who think the ECB made the right decision to increase the interest rate. They argue that the fear that a higher interest rate will worsen the crisis in the peripheral countries is overblown. Even if the ECB increased the interest rate to 2 percent by the end of the year the interest rate would still be lower than inflation, which rose to 2.6 percent annually in March for the euro zone. Spain, the next most likely candidate to require a bailout should something go awry, has experienced a strong bond market over the past several weeks. On CNBC’s Squawk Box, Stephen Roach, Morgan Stanley’s Non-Executive Chairman and Senior Lecturer at Yale University, argued that central banks need to normalize their policy instruments so they can ease again if something were to go wrong. Otherwise, the banks will have to take extraordinary measures to support their economies, e.g. Quantitative Easing 1 and 2 in the United States, and devalue their currency.

Only time will tell whether the ECB made the right decision. The ECB is in a uniquely difficult position because it has to manage 17 different economies ranging from Germany with a 7.6 percent unemployment rate to Spain with a 20.5 percent unemployment rate. The ECB’s focus solely on price stability and strive to display independence leads them to take a more hawkish stance towards inflation than the Fed. However, some view the Fed’s lax monetary policy throughout the 2000s led to the bubbles that caused the financial crisis. Regardless, one thing is certain: Europe isn’t out of the woods yet.

Phil Garrett is a junior finance major and Financial Markets Institute Scholar in the Eli Broad College of Business at Michigan State University.