Tuesday, April 26, 2011

The ECB is throwing gas on a fire

Professor Massimo Pivetti has recently commented on the European Central Bank's (ECB) interest rate increases, that add monetary contraction to the brutal fiscal adjustment that several countries in the periphery of Europe have been subjected to. He says:

"The ECB increased the rate of interest – in what is very likely the first one of a series of increases expected in the next months – with the objective of controlling inflation that accelerated to 2.6% in March from 2.4% in February. Given that this inflation bout has external origins, caused by the increase in the international price of energy, raw materials and foodstuff, the reasoning behind the anti-inflation policy based on dear money is not immediately obvious.

First of all, according to the currently dominant versions of the orthodox point of view about monetary policy, an increase of the rate of interest by the central bank would be only justified if the reasons for the greater inflation including also monetary wages rises would be attributable to imbalances in the conditions of domestic aggregate demand and supply. But certainly not even Trichet would think that today, within euro-system, aggregate demand is pressing beyond the limits of potential product.

He goes on to argue that the ECB policy is like trying to put out a fire by throwing gasoline on the flames, since higher rates of interest translate into higher costs, which firms would pass to their prices.  He notes correctly that the anti-inflationary impact of this policy comes from the appreciation of the euro, which reduces the cost of imported goods, and the reduced wage pressures from an even more depressed economy.  The rest can be read here (if you read in Italian).

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