Letter From Europe
The ECB and Euro-area's economic recovery
Chaklader Mahboob-ul Alam writes from Madrid
On June 8, the president of the European Central Bank raised the euro-zone benchmark interest rate by one quarter percent from 2.50% to 2.75%, the third such increase in six months. Almost immediately stock indexes fell sharply in Europe. As a result, the decision to increase the rate came under considerable criticism as being ill-timed. Some analysts feared that it would stifle economic growth. But others thought that it was too little to have any impact on inflation. An out-of-context discussion on whether an area's interest rate is too high or too low is a futile exercise because it does not take into consideration other relevant economic factors such as interest and inflation rates in other countries with whom it has to compete.First of all, the latest ECB interest rate increase was not an isolated move, but part of a current world-wide trend toward higher interest rates. Central banks in Turkey, South Africa, India, Denmark and South Africaall increased interest rates in the week beginning June 5. Even in the United States, where the benchmark interest rate is already 5%, the Fed will most probably raise it for a 17th straight time to reach 5.25%, when it meets on June 29. The Bank of England may also decide to raise its current rate (4.5%), when it meets on June 21. The job of the president of the European Central Bank is not an easy one. He is expected to stimulate economic growth, keep inflation under control and create employment in the euro area. To make things more complicated, the economic performance of member countries are quite disparate. For example, while Spain is expected to grow by 3% or more in 2006, Germany, if it is lucky will grow only by 1.8%. In the same way, Spain's current inflation rate is 4.0%, while Germany' inflation rate is only 1.9%. So most of the time, the president of the ECB is forced to perform a delicate balancing act under constantly changing circumstances. Despite high energy costs, euro-area economy is expected to grow by 2.4% in 2006, which is 0.6% higher than forecasted only three months ago. Consumer spending also went up recently by 2.8%. This trend is likely to continue in 2007. Inflation in the euro area edged up to an annual rate of 2.5% at the end of May, which is significantly higher than ECB's target of 2%. In raising the interest rate now by a quarter percent, the ECB obviously felt that the risk of slowing the growth was worth paying to keep a lid on inflation. There is no doubt that economic recovery is taking hold in Europe. But this recovery is also facing certain uncertainties like oil prices and impact of higher value-added taxes in Germany, next year. A bigger increase would have strengthened the euro further against other currencies which would have had a negative impact on euro-area's exports. Some of the petroleum producing countries are increasingly using euro as their reserve currency, which is also putting an upward pressure on the euro. Unemployment is falling in France, Germany and Spain. The latest (April) euro-area unemployment rate stands at 8% in comparison with 8.7% at the end of April last year. As a clear sign of economic recovery in the euro-area, employment is growing twice as fast as last year's. The ECB's strategy is to slow the economic growth and not to stifle it by raising interest rates too drastically. While announcing the latest increase, the president of the ECB hinted that the interest rates will keep rising until he is satisfied that the inflation is under control. It is quite possible that the ECB will proceed with a series of measured increases until the benchmark rate reaches 3.5%, which is considered as the optimum rate "consistent with stable inflation and the economy growing at its full potential rate". Chaklader Mahboob-ul Alam is a Daily Star columnist.
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