eirmoney | Difficulty in Setting the Appropriate Euro Interest Rates

Difficulty in Setting the Appropriate Euro Interest Rates

Posted by Emil Okanovic | 23 October 2009

Now that the economies around the world are staging a recovery, the European Central Bank (ECB) will be expected to adjust its monetary policy, i.e. to accommodate its benchmark interest rates, to the new economic realities. However, unlike most other central banks, the ECB has a particularly difficult task of timing and scaling its interest rates adjustments. This is particularly so because its decisions are tailored for 12 different economies — jointly constituting the Euro monetary union—and not any individual economy of the unions member states. Hence, the ECB interest rate decisions are structured in such a way to promote the common economic interest of the area as a whole, even when it comes at the expense of the economy of the unions single member state.

The ECB has a laborious task in defining the appropriate level of interest rates for its monetary union as a whole. This requires taking into account various economic indicators at the level of the Euro-Area as a whole, but also at the level of individual countries. Hence, while some nations assess employment, prices, debt growth and ratios, and other indicators at the aggregate level alone, the ECB has to evaluate these ratios both at the aggregate level for the continent and for each member state within the monetary union. This makes a thorough and complex economic analysis paramount to getting the real picture of the complex economic environment in the union and in each of the union’s member states.

On the other hand, given that the ECB interest rate decisions are made for the wider community as a whole, they may be perfectly suitable for most members, but largely inappropriate for individual economies of the union. For instance, an increase in the ECB benchmark rates may be well-suited to slow down an overheated Irish economy, which may be growing at rates in excess of 4% per annum, well above the rate for the area as a whole. However, the increase in interest rates may be inappropriate for, say, German economy, which could be experiencing subpar economic growth coupled with relatively high unemployment. This hypothetical scenario could be applied to any pair of countries. In another case, if the ECB decision to raise rates helps mitigate inflation in the rapidly growing economies, it could have an adverse effect on the economies of certain union members who are struggling with price levels because of weak underlying economic fundamentals.

The ECB decisions also have a major impact on the Euro’s exchange rate relative to the currencies of the main trading partners. If the ECB increases interest rates, the capital may provide a comparatively higher yield, which would increase demand for the Euro, driving it higher relative to other currencies. However, a more expensive Euro would make European exports more expensive, negatively affecting the external demand for products. As a result, some member states that are heavily dependent on exports could suffer economically, while those states that are dependent on imports, which, subsequently become cheaper as the Euro appreciates in value, could benefit from higher currency rates. The opposite, in case of the Euro’s depreciation, applies as well.

Looking in particular at the effects of the ECB’s monetary policy on the union’s housing and credit markets, it is obvious that borrowers in different countries have different levels of sensitivity to interest rate changes. For instance, mortgage borrowers in Spain have an exceptionally high sensitivity to interest rate changes, given that over 85% of mortgages in Spain are those with variable interest rates. This is a contrast to the economies of, say, Germany and France, in which mortgage borrowers are less sensitive to interest rate adjustments because the majority of mortgage loans come with fixed-term rates. This example illustrates the difficulty that the ECB has in setting the appropriate level of interest rates, given the different exposures of the union’s borrowers to interest rate adjustments.

As described above, the ECB as the monetary authority has a difficult task in making interest rate adjustments at the appropriate time and of the appropriate magnitude that is suitable for the union as a whole and as least detrimental as possible to price stability and economic growth of individual member states of the union. As the economic recovery gains momentum, the ECB will likely increase interest rates before the middle of next year. However, while this, and any following hike in benchmark rates, may be appropriate for certain economies, most notably the large economies, the rise in interest rates will come as a burden to those members that continue to struggle with weak employment and debt burdens, such as Spain, Portugal, and Ireland. Yet, given the absence of inflationary pressures and the persisting weakness in the labor markets throughout, expected increases in interest rates will be limited. Thus, this time around, the disparity in economic conditions within the Euro-Area is limited, especially as regards employment and inflation, making it easier for the ECB to set the adequate interest rate level to the benefit of all its member states.