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Does One Size Fit All? - Outside View by Asad Dossani

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Does One Size Fit All?
Mar 7, 2011

During the week, Jean-Claude Trichet made strong hints that the ECB would raise interest rates during their next meeting in April. The markets reacted strongly to this, pushing the euro higher on anticipation of the rate rise. The reaction from different Eurozone countries was varied. Most opposed were countries suffering from debt troubles (Ireland, Greece, Portugal, etc).

The primary reason the ECB wants to raise rates is that growth has been picking up in some countries (Germany primarily), and the threat of inflation is high, given the rising food and energy prices witnessed in the last few months. The ECB has made it quite clear that the exceptionally loose monetary policy is no longer necessary.

For a country like Germany, raising rates is probably a smart idea. They are growing strongly, and face potentially higher inflation. Given the extremely low level of interest rates, raising them sounds like a good idea. This is especially the case as the real interest rate is negative. (The real interest rate takes inflation into account; it is equal to the interest rate minus the inflation rate). Negative real interest rates can encourage high inflation and asset price bubbles, so it is not desirable.

For indebted countries like Ireland, Greece, and Portugal, raising interest will be a disaster for them. This is simply because they will have to pay higher interest rates on future debt, and because it may reduce investment in their own countries. For economies that are stagnant, raising interest rates can have negative consequences on economic growth and future recovery.

As long as the economies within the Eurozone are quite different, a one size fits all monetary policy is not going to satisfy everyone. Nor is it going to be the optimal policy for any given country. This is one of the fundamental issues with the European Monetary Union, which has yet to be solved.

Part of the issue lies with the mandate of the ECB. There are divisions between central banks around the world as to their mandates. Banks like the ECB have a mandate solely based on keeping inflation low and stable. For this reason, they will be happy to raise rates if they feel prices are going up too fast, even if some of their economies are in recession and are facing high debt levels.

By contrast, the US Federal Reserveís mandate is to promote price stability and full employment. They donít have a specific inflation target, and their policy is often motivated by employment and GDP concerns, rather than inflation. Given the current economic situation in the US, it is very unlikely we would see monetary policy tightening in the US. This is in stark contrast to the ECB.

The ECB has little choice but to adopt a one size fits all policy. What does this mean for the euro? The initial market reaction was positive, as we would expect. However, the real test will be how the indebted European economies respond to the rate rise. If their economic situations further worsened, it could be bad for the euro in the long term.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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