GO
Loading...

ECB Must Face Down Populist Pressures: Economist

The role of consumer inflation expectations has become overplayed in the politicized environment that central banks are now operating in, and to be effective, institutions like the European Central Bank may need to be less fixated on their public credibility, Paul Donovan, economist at UBS, told CNBC.com.

Jean-Claude Trichet
Fabrice Coffrini | AFP | Getty Images
Jean-Claude Trichet

The ECB held interest rates on Thursday at 1.25 percent, but signaled that it was likely to raise them in July as it tries to normalize its monetary policy following the financial crisis.

"Overall, our monetary policy stance remains accommodative, lending support to economic activity. On balance, risks to the outlook of price stability are on the upside. Accordingly, strong vigilance is warranted," ECB President Jean-Claude Trichet said, using the bank's code words for a forthcoming rate hike, "strong vigilance."

"In the basis of our assessment we will act in a firm and timely manner. We will do all that is needed to prevent recent price developments giving rise to broad-based inflationary pressures," he added.

The ECB is diverging from other major central banks in increasing rates into an uncertain economic environment, which is reflective of its unusual fixation on being seen to deal with consumer inflation expectations, analysts have said.

In a report released on Thursday, UBS' Donovan highlighted the strange balance that central banks have to make between making effective decisions and remaining credible with a public and a media that judges the credibility of policy making on a visible targeting of inflation.

The problem, Donovan said, is that consumers are not very good at forecasting inflation.

"I think the ECB is nervous as a new institution, it needs to be seen to be credible," Donovan said.

"In a democratic society, an undemocratic central bank needs popular support. We know that the German electorate loved and revered their Bundesbank, and I think this perhaps is a manifestation of that, that the ECB is pursuing democratic credibility, even though that is not necessarily, in my view, the right way to approach inflation control."

"If the ECB is serious that it wants to control inflation, worrying about the credibility of the central bank with consumers is perhaps not the priority," he said.

The only plausible defence for the ECB's policy would be if it believes that consumers have wage bargaining power, which would mean that its public credibility is important, Donovan said. However, he added, "I would dispute that whether in the euro area as a whole there is wage bargaining power."

With the differences within a two-speed European recovery becoming ever more marked, the ECB's position of hitting the middle ground - gradually increasing rates – is not working well for either end of the growth spectrum, Donovan said. This is likely to further increase the political pressure on the bank.

"Germany needs higher interest rates than they've got at the moment, and at the same time (the ECB) is setting monetary policy which is causing severe problems in the periphery. Not just economic problems, but I would say that there's a growing sense of resentment against democratic populations opposed to an undemocratic institution they believe is making their lives worse," he said.

Contact Europe: Economy

  • CNBC NEWSLETTERS

    Get the best of CNBC in your inbox

    › Learn More*