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Europe Preview: Why a Rate Hike Is a Good Idea

As most of us consider whether we can afford a summer holiday this year, policy makers at the European Central Bank will be resigned to the idea that they will not be able to get away from their Blackberries this summer. On Thursday the central bank meets to decide on rates, and its members must be wishing they could just head to the Mediterranean for the next few months.

While the price of flights will be higher and meals out will be more expensive, sitting on the beach reading the latest James Bond novel or "Then We Came To The End" by Joshua Ferris has to be better than trying to find a way out of Europe’s economic dilemma.

Trying to call an end to the economic crisis is stumping far better minds than mine, and the ECB governing council has some of the best brains in the business. But despite having some of the smartest economists on the planet working on the problem, the central bank cannot answer the following question: What should we do with rates, given that inflation is soaring but growth is significantly weakening?

When most of us are faced with a dilemma at work, we have to act. A CEO faced with falling sales and higher costs will have to sack workers. The line manager will have to tell the workers they are sacked. The workers will have to find another job. Central bankers, on the other hand, can simply say, "We're not sure, so we'll wait and see."

This is exactly what the ECB will do on Thursday. Expect no change. Expect for us to be no closer to the end of the crisis than we are today. Unfortunately, there is only one other option open to the ECB, and that is to raise rates.

A cut, given inflation rates, would simply make it more likely that we would enter recession at some point. If prices keep rising significantly, then the fiscal and monetary response will have to be more drastic somewhere down the road. Therefore, the only option open for the ECB and Ben Bernanke’s Fed is to raise rates and try and slow inflation. In my opinion both central banks should simply get on with it. A long wait for the inevitable will only lead to death by a thousand cuts—and another summer of losses for equity markets across the world.

But how can we raise rates I hear the banks, estate agents and retailers cry, "We are hurting and need support from our policy makers"? Well, I'm afraid this medicine might taste nasty, guys, but believe me you will feel better next summer as a result and may even be able to turn the Blackberry off for a few days in 2009.

Why do I offer this prescription? Well, I believe higher rates are sooner or later going to become a reality. Many in the market believe this is the case as well and will spend the next few months fretting over the timing. If central bankers act now, the uncertainty will be removed. The market may react badly in the wake of a surprise rate hike or two, but once the dust has settled, an early move could help restore confidence.

The emergency rate cuts from the Fed as JPMorgan Chase was plotting its takeover of Bear Stearns did their job and stopped a run on the world’s banking industry. They have not, however, restored the confidence of one bank to lend to another, and with billions of liquidity being pumped into the system, it appears further cuts will not do so either.

Higher rates could cause more short-term pain for the industry and individual borrowers, but an inflationary environment will be far worse. After years of having their cake and eating it too, only some serious medicine is going to overcome their inevitable indigestion.

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