The European Central Bank (ECB) believes it deserves a break. In a flurry of activity it took its benchmark interest rate from 4.25 percent in early October to 2 percent by mid-January. Its president, Jean-Claude Trichet, has hinted that interest rates will be kept at 2 percent when the bank meets on February 5th, though it may act again in March. But the euro-area economy is deep in recession and inflation is falling rapidly. Why delay?
The rationale for holding off seems a bit muddled. One worry is that once interest rates fall too far, it will be hard to lift them again. Low rates make risky assets look cheap, so policymakers may hold off from raising them for too long, for fear of derailing a recovery based on rising asset values. But this is more a plea for wiser policymakers than a case against reducing rates.
Another reason for caution, voiced by Mr Trichet, is to avert a “liquidity trap”. This ambiguous bit of jargon usually refers to situations, such as when interest rates fall to zero, where orthodox monetary policy can no longer affect demand.
Some ECB rate-setters seem to suggest that a liquidity trap can be avoided simply by not reducing interest rates. Many economists fear the opposite: if policy is kept too tight and deflation takes hold it will become harder to induce spending by cutting rates. Consumers will hold back if they know that, with prices falling, their cash will buy more goods in the future. The ECB still has scope to boost demand: if it doesn’t use it, it could lose it.
Yet there may be method in the ECB’s approach. Marco Annunziata at UniCredit thinks it might be a ruse to reassure panicky markets it is in control. A hyperactive monetary policy may sometimes be harmful. John Maynard Keynes thought so: “A large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preferences due to the precautionary-motive may be strengthened.” In other words, people (and banks) may cling to cash more tightly if they are spooked. This might also help explain why the bank seems happy to let market rates drift below 2 percent (see chart) — to talk one game while playing another.
A less worthy reason for keeping official rates on hold is that it delays the day when unorthodox policies are called for. In America the Federal Reserve hit the zero bound in December. Economists at both Goldman Sachs and Macroeconomic Advisers, a consultancy, reckon that the federal funds rate should be -6 percent (yes, minus six), using the “Taylor rule”, which factors in spare capacity and inflation. Unable to push the rate below zero, the Fed is prepared to use other measures, such as buying long-dated government bonds, if that helps private credit markets.
Such a policy would make the ECB uneasy. It is the world’s most independent central bank, designed to be aloof from governments, not to soil its hands by buying their debt. Finding a way to intervene in 16 sovereign-bond markets may be hard. But Thomas Mayer of Deutsche Bank suspects that is not the main barrier to unorthodox easing: “The ECB would like to remain pure. They fear that if they go down this route, they will lose their integrity.”