Trichet Is Not Alone In Facing Policy Dilemmas

By Mohamed El-Erian

The minute Jean-Claude Trichet, the talented president of the European Central Bank, uttered the phrase "strong vigilance", global markets immediately pushed European interest rates significantly higher and the euro strengthened. This understandable reaction to the prospects of an interest rate rise highlights the policy dilemma facing not only the ECB, but also other central banks around the globe.

Mr. Trichet’s remark was largely motivated by the multi-month surge in energy and food prices (which, in the case of oil, has been amplified in recent weeks by the uprisings in the Middle East and North Africa). He and his colleagues at the ECB face the certainty of higher "headline inflation" and, given the recent strengthening of the global economy, the possibility that "core inflation" could also rise quickly as companies look to pass through the impact of higher input costs.

All this is consistent with the ECB’s single mandate of containing inflation. Yet, since August 2007, the ECB has found itself having to do much, much more as it battled the real threats of an economic depression, a banking system collapse and sovereign defaults in the eurozone.

ECB actions have been instrumental in restoring eurozone economic growth, maintaining the stability of European banks and bailing out peripheral economies (Greece, Ireland and Portugal). In the process, the ECB has resembled in many respects the Federal Reserve in the US whose decisions to pursue unconventional policy stances have had both benefits and unintended negative consequences at home and abroad.

Until now, very few central banks have made explicit policy trade-offs among the multiple objectives they have been forced to pursue. Those that have, such as in Brazil and China, have been able to tighten monetary policy in the accommodating context of strong economic growth and relative domestic financial stability. This is now changing rapidly.

Thursday’s comments by Mr. Trichet indicate that the ECB now faces much harder trade-offs; and the stakes are significant. Should the ECB increase rates to counter what is likely to be growing inflationary pressures; or should it maintain a loose monetary policy stance to continue to recapitalise gradually the struggling segments of the eurozone economy?

There is no easy answer. The institution’s credibility draws heavily on its ability to deliver low and stable inflation. This, combined with the economic strength of Germany, warrants an early interest rate rise.

Yet such a policy response – and the likely market reactions to it, such as we are seeing today in the shape of higher market interest rates and a currency appreciation – would undoubtedly aggravate the uphill struggle facing peripheral economies that have yet to address their large debt overhangs and related inability to deliver high economic growth.

Many people will be watching the ECB very closely, including other central banks that face similar policy dilemmas down the road. Back in the summer of 2007, the ECB responded to higher commodity prices by raising interest rates. It will be tempted to do the same in the next few weeks. Let us hope that this is accompanied by a more effective EU approach to addressing the debt problems of the periphery and to recapitalising more aggressively the region’s banks.