Monday, April 14, 2008

The Maradona theory of interest rate steering - will the ECB need the “hand of God” goal?

EURO 2008 will be in focus in all great Asian betting countries until next July. The question is about football (soccer), not about trading currencies. But, football inspired Mervyn King, Governor of the Bank of England, to develop his Maradona theory of interest rate steering by a successful central bank; see his speech “Monetary Policy: Practice Ahead of Theory”, 17 May 2005

The Maradona theory deals with the power of expectations about the future conduct of monetary policy affecting the choices of households and firms today.

In the 1986 World Cup in Mexico City, Diego Maradona scored against England after a 60 meter run in a straight line while beating five English players. This spectacular straight-on performance was possible because the defenders reacted to what they expected Maradona to do, to move either left or right.

Monetary policy can work similarly, Governor King described. Market interest rates react to what the central banks are expected to do. When the households and firms expect the official interest rates to move either up or down, those expectations are sometimes sufficient to stabilize private spending while the steering rates in fact move very little.

Hence the action is in the forward rates, in the expected future short rates of interest. They effectuate the outcome. The experience of the Bank of England in 2002 perfectly supports the Maradona theory. Even thereafter the official bank rate has shown considerable stability in contrast to previous decades.

Neither is the behavior of the Eurosystem interest rates against the Maradona theory. The steering rate of the ECB has moved within two percentage points since September 2001 and stayed at 2.00 percent from June 2003 to December 2005.

The Governing Council of the ECB has kept its steering rate on hold since June 2007. Will it score as Maradona to deliver price stability without raising the steering rate?

Prior to last Thursday’s meeting of the Governing Council, financial markets expected two rate cuts of 25 basis points from the ECB by the end of this year, but no longer so after the meeting.

Other powerful forces help the ECB. Strong euro re-diverts world spending from goods and services produced in the euro area toward production outside. Housing markets have cooled in parts of the euro area.

Funding from equity issues is more expensive because of the drop of equity prices: to a raise a given euro amount for investment finance, the companies must hand on a bigger slice of the future dividends to the subscribers of new issue than before the drop of equity prices. High-yield corporate bond issues must similarly promise a higher yield after the re-pricing of their risks. In principle, these make investment finance more expensive.

But, bank borrowing by the non-financial companies is growing briskly, by almost 15 percent annually in February, which may be due to the companies substituting market funding for bank borrowing. It is a sign that investment spending will not be cooling soon. Projects take a long time to complete.

Anyhow, the ECB faces a dilemma in its primary objective, price stability. It may need Maradona’s first goal in the above match. It was the “hand of God” goal that Mr. King described as “an exercise of the old ‘mystery and mystique’ approach to central banking,” acting unexpectedly, time-inconsistently and against the conceived rules.

Such a behavior by the ECB may well be the action which is best consistent with its overall strategy of meeting the inflation target.

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