Last week's decision by Mr. Jean-Claude Trichet, the new French President of the European Central Bank, to leave European interest rates unchanged does not augur well for the European economy under his stewardship at the ECB. For rather than meeting the challenge of a sharply appreciating euro by bold monetary policy action, Mr. Trichet chose to hew the same ultra-conservative, anti-inflation line of Mr. Wim Duisenberg, his dour Dutch predecessor. By so doing, Mr. Trichet has substantially increased the likelihood that Europe's major economies will relapse into recession over the next few quarters. He has also increased the probability that the ECB will overachieve its 2 percent inflation target.
By leaving interest rates on hold, Mr. Trichet threw away a golden opportunity to establish his credibility as a shrewd policymaker at the outset of his mandate. In this respect, he might have learnt from Alan Greenspan who, by his deft handling of the October 1987 stock market collapse, established his credibility as a bold central banker within a few months of taking the helm at the Federal Reserve Board. Mr. Trichet might also have learnt from Mr. Greenspan's more recent bold and pre-emptive policy response to the bursting of the U.S. equity bubble in March 2000. Following the bursting of that bubble, Mr. Greenspan cut U.S. interest rates by 550 basis points to their lowest levels in 45 years with the deliberate objective of cushioning the U.S. economy from the deflationary impact of the bubble's bursting.
The daunting challenge facing Mr. Trichet at the very outset of his mandate is a sharply appreciating currency at a time that the major European economies are barely recovering from their mid-2003 recessions. Indeed, over the past year alone, the euro has appreciated by more than 20 percent against the U.S. dollar and by around 10 percent against a basket of currencies of Europe's major trade partners. Given the unprecedented large U.S. external current account deficit, as well as the reduced foreign appetite for investing in the U.S. in the wake of the bursting of the equity bubble, there is every reason for Mr. Trichet to expect that the U.S. dollar will continue to decline against the euro in the absence of concerted policy action.
An appreciating euro should be viewed by the ECB as the macroeconomic policy equivalent of a tightening in European monetary policy. By making European exports more expensive in foreign markets, an appreciating euro discourages European exports. By the same token, by cheapening the domestic cost of imports, a stronger euro causes domestic demand to shift away from European produced goods towards foreign imports. In addition, by directly lowering the cost of imports and by increasing foreign competition with domestic producers, the stronger euro has a directly favorable impact on domestic inflation. These deflationary effects of an appreciating currency are significantly more important in Europe than they would be in the United States, given the greater degree of openness of the European economy.
There are two plausible reasons that might explain, though not justify, Mr. Trichet's behavior. First, as a newly appointed French president of the ECB, Mr. Trichet might be wanting to solidify his credentials as an inflation hawk as he earlier did with his franc fort policy at the Banque De France. Cutting interest rates now might be interpreted as being soft on inflation. Second, Mr. Trichet might be reluctant to ease monetary policy so soon after both France and Germany so fragrantly breached EMU's Fiscal Stability Pact. Mr. Trichet might fear that European finance ministers might interpret an interest rate cut now by the ECB as an indication that the ECB is condoning irresponsible fiscal behavior.
Lofty as Mr. Trichet's motivation might be, his tardiness in cutting European interest rates could prove to be a costly mistake. By maintaining interest rate differentials in favor of Europe, Mr. Trichet runs the distinct risk of fueling the euro's rise against the dollar that would only exacerbate the present deflationary pressures on Europe. At the same time, by leaving European interest rates unchanged, Mr. Trichet does nothing to offset the deflationary impact on the European economy of the strong currency appreciation that has already occurred. This is unfortunate not only for Europe but also for the global recovery. One can only hope that Mr. Trichet reverses course soon before more damage is done to the global economy.
Desmond Lachman is a resident fellow at the American Enterprise Institute.