Inflation fears finally force the European Bank into action.jpg

Inflation fears finally force the European Bank into action

EUROZONE INTEREST rates had not changed for two-and-a-half years, they had not risen for five. But all that changed on December 1, when the European Central Bank (ECB) finally tightened monetary policy with a quarter per cent increase to 2.25 per cent.

The decision was not without controversy. If you have Euro savings and/or wish to see the bank control inflation, you’ll be pleased by the move. On the other hand, finance ministers and businesses were against it, and anyone with a Euro mortgage would have preferred rates to stay as they were.

In mid November, ECB president, Jean-Claude Trichet, effectively pre-announced the decision at a Frankfurt banking conference. He described the ECB as “one of the most predictable central banks in the world”. I don’t imagine there were any arguments there – I can’t remember the ECB taking us by surprise (which is a good thing from an investment point of view).

There were quite a few arguments, however, against raising interest rates, but the ECB went ahead with its plans, albeit with some internal debate. While Trichet insisted the governing council came to a unanimous decision, he admitted that some had wanted rates to remain unchanged, while others had pushed for a larger increase.

The main reason for this increase was inflationary concerns. In November, inflation was 2.4 per cent, the ninth month that it had been at or above the upper two per cent limit the ECB is meant to adhere to under the Maastricht Treaty. ECB forecasts now show inflation ranging between 1.6 per cent and 2.6 per cent next year.

Trichet warned some time ago that he would be “very vigilant” on the inflation issue. He said the Bank had been “very bold” to hold interest rates for so long and emphasised that its credibility would be at risk if it didn’t act to head off inflationary dangers.

On the other hand, higher interest rates can dampen growth and many feel that with Eurozone growth still sluggish, rates should have been kept at two per cent a while longer to give the economy more time to get back on its feet.

Trade unions and small businesses appealed to the ECB to change its position, saying the appeals of governments and businesses, which would have to cope with the damaging effects of a rate rise, must not be ignored at all costs.  

The Organisation for Economic and Co-operation (OECD) had made a last ditch warning that the move could harm Europe’s fragile economic growth. In its Economic Outlook, published two days before the ECB meeting, it advised that “monetary tightening should wait until the recovery gathers enough momentum and becomes more resilient”. It predicts Eurozone gross domestic product will only grow 1.4 per cent this year and 2.1 per cent in 2006. (It was very optimistic on global growth, however, describing it as having been “exceptionally vigorous” since spring and resilient in the face of large oil price increases.)

Politicians have also had their fair share to say about the ECB’s policies, and the two camps don’t appear to be on the best of terms. When finance ministers called for a rate cut a while back, the ECB insisted it was “independent” and wouldn’t be swayed by politicians. It was not persuaded again this time, even though the ministers made it clear they weren’t ready for rates to go up.

Jean-Claude Juncker, Luxembourg Prime Minister and political face of the single currency, broke his silence on the subject in the lead up to the announcement. He publicly warned that a rate rise would hit Eurozone growth and claimed that inflation was under enough control for monetary tightening to be unnecessary.  

Relations between the ECB and Eurozone finance ministers have been tense for some time, and the ECB publicly criticised their decision to weaken the Stability and Growth Pact – the rules underpinning the Euro – warning that the changes could lead to a buildup of public borrowing and increase inflationary pressure. The politicians ignored the ECB.

The news that the council was split on, if and how to raise rates and the negative response, could well mean that we won’t see another rise for some time. In any case, Trichet had already announced that rises would not be ongoing: “It is not an ex ante decision of the Governing Council meeting today to engage in a series of rate increases. We have decided to increase rates by 25 basis points because we judge we are in line with our duty, our mandate, which is to preserve price stability.”

Analysts are divided as to what will happen next. Some say we won’t see a rise to 2.5 per cent before March, others say before autumn. On the other hand, I have read a prediction that Euro rates will hit three per cent by the end of 2006.    

If you have Euro savings, you’ll want rates to rise, although if you’re retired, the last thing you need is increasing inflation! With the ECB base rate at 2.25 per cent and inflation at 2.4 per cent, your Euro deposits are still losing spending power. The bank is keeping a close eye on inflation, but it also has to take economic growth into account. It’s a fine balance and, with the ECB council divided on the issue, it’s going to be interesting to see what happens next. You need to consider how you maintain spending power while Euro deposit rates remain below the rate of inflation, or your future financial position will be at risk.

• To keep in touch with the latest developments in the offshore world, check out the weekly news update on our website,