When the European Central Bank lowered interest rates last week, it thought it was giving the market what it wanted. For months the bank had been criticized for failing to reduce its benchmark rate, while other central banks were lowering rates to stimulate growth. But rather than eliciting praise, the reduction has mostly prompted scorn. RFE/RL correspondent Mark Baker reports that the timing of the move and the bank's explanation have led some to question the bank's credibility.
Prague, 15 May 2001 (RFE/RL) -- The European Central Bank is learning the hard way how to please and how not to please the markets.
Last week, the ECB -- the central bank for the European Union's 12-country euro-zone -- decided to reduce its main interest rate by 0.25 percentage points, to 4.5 percent, as a way to stimulate the slowing economy. A rate reduction tends to promote economic growth by making it cheaper for companies and individuals to borrow money.
The bank was expecting the markets to welcome the rate reduction as long overdue. The ECB has held interest rates steady since last fall, while central banks around the world -- including the U.S. Federal Reserve -- have reduced rates to stimulate growth. During that time, governments and organizations sharply lowered their projections for economic growth in the euro-zone. Many organizations, including the International Monetary Fund, had been pressing the bank to cut rates.
But far from being welcomed, the decision to reduce rates has been widely criticized.
Nicholas Stamenkovic, of Nomura Securities in London, tells RFE/RL the reduction will help the euro-zone's economies. He says, however, that the timing of the move and it justification unsettled the financial markets and left many wondering if the bank knows what it is doing.
"The ECB's rate move last week was welcome in the sense that it helped alleviate the downward growth in [the 12-country euro-zone]. The problems that the markets had with the decision was that, one, the ECB had not prepared the markets for the rate move, and, two, the comments from the whole host of ECB officials up to the meeting signaled that they were still concerned about inflation."
Stamenkovic says that just days before the rate move, officials of the ECB's governing council were emphasizing the dangers of inflation. He says that the markets were caught off-guard and now question whether the bank still takes its mandate of maintaining price stability seriously. A decision to reduce interest rates can increase inflationary pressures by putting more money into the economy, and inflation in the euro-zone is still well above the 2 percent annual level the ECB considers to be benign.
To be sure, central banks around the world face a difficult task. On the one hand, they can't influence the markets by making their intentions too obvious. On the other hand, they have to be predictable so as not to unsettle the currency, bond, and stock markets that look to the banks for indications of the health of the economy.
"I think the important thing here is consistency. It's fine to surprise the markets as long as you have the economic justification to do so. The problem is that the ECB's mandate is price stability. And with inflation above the ECB's 2 percent target, and moving away from that, the markets were clearly concerned that the move is undermining the ECB's anti-inflation credibility."
Stefan Schneider, an economist at Deutsche Bank who follows the ECB, agrees. He says the bank failed to give clear signals of its intentions at meetings ahead of last week's decision. To the contrary, the bank sent out a clear signal that it would not lower interest rates:
"After these meetings, we basically got one simple, unified message from the ECB: 'We are not prepared to cut rates as long as the headline inflation in euro-land is still ticking up' -- which it currently is. Basically, after this message, the ECB cut rates, and this caused some confusion and consternation with the markets. It is very difficult to interpret this U-turn."
For his part, ECB President Wim Duisenberg last week justified the rate reduction by saying that, based on statistics on economic growth, inflation, and money supply, the 4.5 percent rate is appropriate:
He told reporters in Frankfurt:
"On the basis of the information available, this is the appropriate level of interest rates to ensure that the euro area will be able to maintain price stability and thereby to continue sound economic growth."
Duisenberg said the bank had recently discovered new data to suggest the supply of money circulating in the economy was not growing as fast as previously thought, leaving some room to reduce interest rates.
But Schneider says he and many others simply don't believe the bank's explanation.
"To be honest, this argument looks a little artificial. I mean there might be something in it, but in the market hardly anyone believes that this insight [on money supply] just came out of the blue."
Last week's decision has again raised fears that have dogged the ECB since its inception two years ago: that the bank -- linking 12 separate economies -- is too large and unwieldy to be credible. Growth in Ireland, for example, is well above the EU's average and officials there are looking to cool, not stimulate, the economy. In Germany, on the other hand, the economy continues to slow down.
Schneider says in 1999 the bank did not reduce rates quickly enough in response to the Asian economic crisis the year before. And last year, it was too slow to raise rates again to respond to rapid growth.
"I think even if you are a somewhat more positive observer than maybe some of the Anglo-Saxon observers, I think it's very difficult to come to the conclusion that the ECB has done a good job in terms of credibility."
He blames the size of the governing council -- 18 members representing 12 countries.
"The ECB council is still a very heterogeneous body, where it probably takes somewhat longer for them to reach a consensus view."
Nomura's Stamenkovic agrees that the bank's structure is unwieldy, but says the bank must still do a better job of communicating its intentions.
"I think there are two problems here: one is communication. The ECB has not done a good job communicating its intentions to the market. Two: there are 12 different countries there, and there are differences concerning growth and economic performance across the board. So consequently, that's made the ECB's job difficult. We have no idea if there is dissension among the ranks."
The ECB will have plenty of opportunity this year to improve its communication skills. Organizations and governments continue to lower their projections of growth for the euro-zone this year, maintaining pressure on the bank to make more rate reductions.
The bank meets every two weeks to debate changes in interest rates. Schneider, for one, says he expects another 0.25 percentage point reduction in the coming weeks.