How the ECB Will Raise Interest Rates

Last week, Ben Bernanke, Federal Reserve Chairman-Elect, suggested that he would continue along Alan Greenspan’s path of measured rate increases.

In the European Union, where interest rate increases are expected as early as next week, it looks like policy makers at the European Central Bank (ECB) might have a different plan.

Last week, almost immediately after ECB President Jean-Claude Trichet stated that “after two-and-a-half years of maintaining historically low interest rates, I consider that the governing council is ready to make a decision on interest rates,” the stock markets priced in up to three 25-point increases in the benchmark rate over the next year.

On Monday, however, Trichet made a statement to the Committee on Economic and Monetary Affairs of the European Parliament that downplayed any ideas of a series of rate increases over the near term.

“I don’t see at all, ex ante [beforehand], the start of a series of augmentation of interest rates,” he said, explaining that the European Central Bank would be looking at interest rates on a monthly basis, as needed.

Trichet also elaborated on the intention of the upcoming rate hike: the rate increase expected on December 1, 2005 “would aim at coping with inflationary risks in order to maintain and preserve full confidence in price stability and to continue solidly anchoring inflation expectations. This move would therefore contribute to sustainable growth and job creation in the euro area.”

Some of the positive statements the ECB President made in regards to the EU economy included:

— “the most recent data and indicators available have confirmed our working assumption of a gradual ongoing strengthening of economic activity”

— “euro area GDP rose by 0.6% quarter-on-quarter in the third quarter of 2005”

— “the strengthening of monetary growth observed since mid- 2004 has gained further momentum over the past few months”

— “it is projected that ongoing growth in global demand will continue to support euro area exports”

— “on the domestic side, it is projected that investment will benefit from continued favourable financing conditions and from the robust growth of corporate earnings”

— “consumption should gradually recover, broadly in line with expected developments in real disposable income”

 What I get from the transcript of ECB President Jean-Claude Trichet’s statement on Monday is that he is confident in the economic recovery of the European Union, but he is not over- confident.

 His decision to weigh the merits of future interest rate increases on a month by month basis seems like the intelligent thing to do — it makes a lot more sense to an economy watcher like me than Greenspan and Bernanke’s plan to just continue raising interest rates on a predetermined schedule.

 For the success of any economy, flexibility in response to changing conditions is key, and it looks as though the ECB understands this. In turn, I expect the European Union will be able to achieve a “gradual ongoing strengthening of economic activity.” I only hope North America will be able to enjoy the same economic strength.