Central banks move in different directions

April 7, 2011

During the financial crisis, the world’s central banks united around one goal: cutting interest rates and flooding the global economy with cash. Now, the great divergence has begun.

The European Central Bank raised its interest rate target Thursday, ending a more than two-year span of keeping the rate at an all-time low of 1 percent. The 17 nations that use the euro thus join a handful of other nations, including China and Australia, where authorities are trying to tighten the money supply to cool their economies and combat rising prices.

In contrast, the Bank of England and Bank of Japan, in meetings Thursday, affirmed their very low interest rate policies. And the Federal Reserve has pledged to keep its target for interest rates near zero for an “extended period” and is still undertaking a program of aggressive stimulus by buying billions of dollars’ worth of Treasury bonds through June.

The divergence will shape the world economy over the year ahead. Higher interest rates in Europe — in addition to Thursday’s rate increase to 1.25 percent from 1 percent, investors expect another half-percentage point rate rise by the end of the year — are strengthening the value of the euro relative to the dollar and other currencies. The European rate increases could also give developing nations whose economies are growing rapidly, such as India, China, and Brazil, more leeway to increase their interest rates without losing competitiveness to Europe.

But the ECB action comes at a cost: It will slow European economic growth and make it even harder for governments groaning under massive debts to find a way out. This week, Portugal asked the European Commission for a bailout, which could be as much as $100 billion, and the nation’s dire fiscal situation would benefit from lower interest rates and a cheaper euro.

The value of the euro was little changed against the dollar Thursday, at $1.43, up from $1.29 in January when investors first began to think an interest rate increase was in the offing. In a news conference after the announcement, ECB President Jean-Claude Trichet said, “We did not decide that it was the first in a series of interest-rate increases,” but added that the central bank will continue to do what is necessary “to ensure price stability.”

The different approaches to monetary policy on the two sides of the Atlantic reflect differences both in the states of the U.S. and European economies, and in the mandates with which the Fed and ECB are charged. The ECB is charged with maintaining overall inflation just below 2 percent; with food and energy prices rising steeply, inflation in Europe has been well above that pace lately.

The Fed is tasked by Congress with maintaining stable prices and low unemployment. Chairman Ben S. Bernanke and other Fed leaders have been more inclined to look past price changes caused by fluctuations in commodities such as oil, corn or copper, viewing them as not indicative of true inflation trends. And they tend to worry more about the state of the job market than their European counterparts, given that employment is formally part of their mandate.

The differing approaches to policy are a reflection of “the Fed having decided to focus on core inflation while the ECB focuses on headline inflation,” said Peter Hooper, chief economist for Deutsche Bank Securities.

While the higher interest rates will make the situation for Portugal and other financially troubled European nations such as Greece and Ireland more difficult, Trichet and the ECB are trying to clearly signal that they are keeping monetary policy separate from their efforts to bail out those nations.

Bailouts are already wildly unpopular among the Germans, and by making clear that the ECB will not let inflation get out of hand, the bank may face less criticism for its crisis response efforts.

“For the ECB, more important than the anti-inflation mandate is the mandate to sustain the euro’s credibility,” said Steve Blitz, senior economist at ITG Research.

Market analysts said Thursday that domestic political concerns may cause the German government to be tougher on Portugal than it would have been at other times, as Chancellor Angela Merkel’s coalition is on unsteady footing and the previous bailouts of Greece and Ireland have not been popular inside the country.

“Right now it’s very difficult for Merkel to win electoral support with any European issue,” said Carsten Brzeski, a Brussels-based senior economist for ING Group. He said there were few obvious policies that Germans could ask Portugal to change, unlike Ireland or Greece.

“With Portugal, it’s simply a totally undynamic economy,” he said. “Which makes it tricky to find one bargaining chip to ask for.”

Staff writer Michael Birnbaum in Berlin contributed to this report.

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