Will the ECB deliver price stability?

The Governing Council of the European Central Bank ECB need to raise its steering rate, but to cut the rate of its lending facility. The council will meet on Thursday, 10 April 2008.

The ECB is on the verge of losing its credibility in delivering price stability in the medium term. The annual rate of increase of the harmonised index of consumer prices HICP in the Euro area has hovered above 3 percent since last November. The recent preliminary estimate for March 2008 is even 3.5 percent, double the rate in last August.

The actual consumer price index CPI, including energy and food, has risen even faster than HICP, but the latter is catching up the headline rate of the CPI. This must mean that the expected rate of inflation ERI is converging to the realized rate of the HICP and CPI.

The task of all central banks is nowadays regarded as managing inflation expectations. When the ERI exceeds the realized rate of the HICP inflation, the latter is accelerating. When the ERI falls short of the realized HICP rate, the latter is decelerating. In equilibrium, the expected and realized rates are equal.

But, the ECB aims at delivering price stability, maintaining the realized rate of the HICP inflation close to, but below 2 percent. Because the realized rate has doubled since last August, the unobservable ERI must have flown well above the ECB target long before that, perhaps since the beginning of 2006.

Christian Noyer, Governor of the Bank of France, said in Prague last week: “A solid anchoring of inflation expectations remains a pre-requisite for rate cuts in times of heightened financial uncertainty and downside risks to growth.''

But, will the ECB need a cut of its steering rate? Its President Jean-Claude Trichet clearly emphasized in the hearing at the European Parliament 26 March 2008 that “In the view of the Governing Council, risks to the medium-term outlook for inflation are on the upside,” citing a number of factors from “further rises in oil and agricultural prices” to “administered prices and indirect taxes.”

This assessment hardly prepares financial markets for anchoring inflation expectations to the ECB target rate of inflation in the medium term or, for a rate cut.

To manage inflation expectations, the ECB need to raise its steering rate, the minimum bid rate of the refinancing operations, to 4.25 percent.

And, the management of the fragile financial system needs a rate cut of the ECB lending facility to 4.75 percent which is the current level of the 3 – 12 month Euribor interest rates.