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Kissing an Era Goodbye: To Fight Inflation, Europe Ends Cheap Money Strategy

The era of cheap money is ending: For the first time since the financial crisis, the European Central Bank raised interest rates by a quarter point to 1.25 percent on Thursday. ECB President Jean-Claude Trichet wants to limit inflation and apply the brakes on speculators.

For the first time in the European Central Bank's history, ECB President Jean-Claude Trichet on Thursday changed interest rates before the United States. Zoom
AFP

For the first time in the European Central Bank's history, ECB President Jean-Claude Trichet on Thursday changed interest rates before the United States.

In a significant shift in its monetary policy marking an end of several years of extremely cheap money, European Central Bank (ECB) President Jean-Claude Trichet announced Thursday an increase in the leading interest rate by 0.25 percent to 1.25 percent. The interest rate hike marks the first time it has been increased in nearly three years.

Financial experts had widely expected the increase, and Trichet suggested it would be coming in March when he said the ECB would use "strong vigilance" in view of creeping inflation.

Preliminary figures suggest that the inflation rate within the euro zone has already reached 2.6 percent, 0.6 percent higher than the declared ECB goal of 2 percent or less. Thursday's step is also aimed at reining in speculation fuelled by supplies of cheap money. Market analysts are predicting the increase will be the first in a series and that interest rates could reach 1.75 percent by the end of the year.

Germany's leading economic research institutes have welcomed the increase as well. In their spring reports released on Thursday, they said the modest change was largely symbolic. They said that a rapid increase is unnecessary but that the ECB was also making clear that it would move decisively to curb sharp inflation in wages and prices.

With Most Economies Recovering, ECB Decides to Move

Thursday's move to raise interest rates marks the end of an era in the central bank's short history. For nearly two years, the ECB lent money to European banks at an interest rate of 1 percent, a record low. By sinking the interest rate in May 2009, the central bankers moved to spur economic growth in the same manner deployed around the world. The global crisis caught many European firms off guard, especially when lending from their banks largely dried up because of the credit crunch. In order to get the flow of money moving again, the ECB offered radically low interest rates.

Now, most European countries are experiencing economic recoveries. After falling deep into recession at the peak of the crisis, Germany's economy has since experienced the greatest boom seen in years.

For his part, Trichet also had a personal interest in seeing an increase in the interest rate. Under his leadership, the ECB began the controversial practice of buying bonds floated by crisis-plagued euro zone countries, which otherwise had to sell them on the market at extremely unfavorable terms. The parting head of Germany's central bank, Axel Weber, continues to strongly criticize the moves today. With the bonds still burdening his legacy, it is hard to imagine Trichet will want to leave office as planned in October and also be remembered as a man who kept interest rates low despite rising inflation.

Another argument in favor of Thursday's rate increase was that the policies of cheap money had encouraged investors to speculate. "It is not without reason that commodity prices have risen so sharply," Jörg Krämer, chief economist at Germany's Commerzbank, told reporters. "This shift is overdue."

Because the interest rate increase is so small, experts do not believe it will have any significant impact on consumers. Max Herbst, an analyst at the financial consultancy FMH, described the move as a "symbolic increase," to combat inflation.

Value of Euro Will Likely Rise

The most likely effect of the interest price hike could be a rise in the value of the euro because higher interest rates will make it more attractive to deposit money in the euro zone, which will in turn drive up the exchange rate of the common currency. Indeed, the value of the euro has been rising in recent days in expectation of the rate hike, from $1.35 in February to $1.42 today. Economists at Germany's Unicredit anticipate that the euro will reach $1.48 by the end of the year. That calculation takes into account two further interest rate hikes, each by a quarter percent -- moves most economist agree will happen by the end of 2011.

The appreciation of the euro will make exports more expensive, but German business leaders do not expect major problems for Germany. "Spain, Portugal and Ireland are the losers in this interest rate hike," said Unicredit analyst Andreas Rees, because in addition to slowing rising prices, interest rate increases make lending more expensive.

In all three of these countries, most real estate is financed with short-term mortgages. In Ireland, which has already received a European Union bailout, 67 percent of these loans only have binding interest rates for one year. In Spain, that figure is 90 percent, and Portugal, which on Thursday moved to request an EU bailout, that figure is even higher, at 99 percent. By comparison, that share in Germany, France or the Netherlands is only 20 percent. Soon residents of the troubled countries who are already suffering under the crisis, could face higher mortgage payments.

'A Gigantic Policy Mistake'

In the run-up to the rate hike, some analysts criticized the move as a "gigantic policy mistake." "It remains to be seen whether, in view of Portugal's imminent collapse, worrying about inflation being marginally above the 'sacred' 2 percent level is entirely appropriate at this stage," Jeremy Batstone-Carr, director of private client research at Charles Stanley, said.

Economist Michael Heise, the chief economist at German insurance giant Allianz believes that concerns over the threat of a division of the euro zone are exaggerated. "The economic effects will be limited," he said.

The ECB's move stands in contrast to the positions of central banks in Britain and the United States. In London, the Bank of England said Thursday it would maintain its interest rate at a record low of 0.5 percent in order to help shore up its stalled economy, despite an inflation rate that has already reached 4.4 percent. And in Washington, the Federal Reserve Bank, which since December 2008 has had an interest rate of between 0 and 0.25 percent, will also maintain its historically low rates.

This also marks the first time, shortly before he leaves office, that Trichet has been the first to reverse its course on interest rates before Washington's Fed. But Unicredit's Rees praised the move, saying he also considered this to be the correct decision. "It is time to normalize monetary policy," he said.

dsl -- with wires

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BTraven 04/08/2011
The problem for Trichet is that countries like Spain need low interest rates while Germany would welcome higher rates. The aftermath of the increase, as hinted in the article, could be more foreclosures in the three countries mentioned. Banks have to write off further credits and many people will lose their homes.
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