Although the Federal Reserve has cut rates by 225 basis points since September, the European Central Bank (ECB) has kept its main policy rate unchanged at 4.00% since last tightening policy in June.
Although the fallout from the subprime mortgage debacle is dimming the outlook for growth and leading to volatility in most financial markets, ECB policymakers have maintained that the primary risk to the Euro-zone outlook is inflation rather than sub-par growth.
As Exhibit 1 makes clear, CPI inflation indeed has shot up over the past few months.
Unlike the Federal Reserve, which has a “dual mandate” of stable prices and low unemployment, the ECB has one primary objective: price stability. Although the ECB does not really define what “price stability” means, it is generally believed that policymakers want to keep the overall rate of CPI inflation around 2% per annum.
Although the core rate of CPI inflation is near the ECB's implicit target, policymakers have expressed concern that the sharp rise in inflation recently could put upward pressure on the core rate of inflation due to wage increases.
Up until this month's policy meeting, the ECB had an implicit “bias” to tighten policy further to insure that inflationary expectations do not become entrenched.
However, recent data showing that growth is slowing quickly appear to have caused a rethink in Frankfurt. As shown in Exhibit 2, the purchasing managers' indices for the manufacturing and service sector both remain above 50, which marks the demarcation line between expansion and contraction.
However, the service sector PMI has dropped precipitously since last summer, and currently stands at a level last seen in 2003. Although the indices do not indicate that the Euro-zone is currently in recession, they do suggest that growth has slowed sharply.
Indeed, ECB President Trichet acknowledged in this press conference following the policy meeting on February 7 that “incoming data have confirmed that the risks surrounding the outlook for economic activity lie on the downside.” Apparently, the idea of a rate hike was not discussed at the policy meeting, like it has been at previous meetings.
