Political pressure on the European Central Bank not to raise interest rates as it might undermine the fragile economic recovery appears, to have influenced the Bank's decision for a quarter percentage point raise.
ECB President Jean Claude Trichet said that a series of raises was not planned and the latest was only in response to inflationary pressures and "to adjust our accommodative economic policy stance." He admitted that some members in the 18-member governing council had urged for a half percentage point raise, while others had wanted rates to remain unchanged. Finally, a compromise was reached.
ECB, having taken over Eurozone monetary policy in 1999, had not changed interest rates since June 2003, when it announced half a percentage point cut to two percent, a level regarded as an attempt to avoid deflation. Unlike the US Federal Reserve over the past year, said President Trichet, ECB had not reached "ex-ante...decision to engage in a series of interest rate increases."
The division in the ECB council reflects difficulties in arriving at a consensus on future raises. The 311 million citizens in the Eurozone want ECB to defend price stability. ECB, unlike other Central Banks (US Federal Reserve, Bank of England and the State Bank of Pakistan) bases its decisions on analysis of money supply figures as they indicate a long term inflationary trend instead of an inflation target.
The other contrast with the US Fed and SBP is ECB's distrust of lowering cost of living index by excluding the impact/weight of POL/transport cost from the inflation index under a nomenclature of "core" inflation to make the inflation figure benign.
President Trichet rightly emphasised that this is inappropriate. ECB's policy of not changing interest rates for two years but keeping growth in money supply in check stands vindicated as markets have delivered a big reduction in long term cost of debt (10-year bond yields have dropped by one percent to 3-4 percent) to European businesses and households.
SBP, like the Bank of England and the Fed, does not have a policy framework of dealing with asset prices. Fortunately, after the economic slowdown post 9/11, the US economy turned around on Fed's accommodative monetary stance, ie pumping money and cutting interest rate to nearly one percent.
In the process, however, the housing bubble was created and falling stock prices soared again. Fed, unlike BOJ, was not put to a test of its policy framework with zero fund rate. Had the Bank of Japan kept a broad money target like ECB's, Japan would have exited out of deflation many years ago.
Japan as well as other Asian economies could not handle the crises when the asset bubble burst. Banks were left holding real estate against which they had lent aggressively in the face of an economic downturn. Defaults on auto loans and credit cards soared, while all time fresh bankruptcies were recorded.
Learning a lesson from Japan's experience, for 2005-06 SBP should have kept a lower target for money supply in order to drain the system of excess liquidity pumped in the previous two years.
It is easier for people to make more money by speculating in real estate and the stock market than to operate an industry profitably. The endeavour to kick-start the economy, and achieve high growth, through an accommodative monetary policy with all time low lending rates and no check on the rise in bank credits, has resulted in raising land prices beyond the reach of even the upper middle class.
The broker community has reaped a windfall of such a magnitude that they now outbid big industrialists in the privatisation auctions. A couple of years ago SBP had banned brokers from becoming directors on bank boards. But under SBP's accommodative policy and government's sweetener of capital gains exemptions, they have ended up buying banks.
Rapid credit growth is a well-spring of asset price bubbles. Slow economic growth in Eurozone has nothing to do with ECB's monetary policy. It stems from high taxes, restrictive labour laws on hiring and firing, rigidities of an old structured society and hesitation to move from a place where a person is born instead of moving to a city where work is available.
This is also the basic difference between Eurozone and the US despite education and skills on both sides of the Atlantic being at equal levels. The response of US businesses to adjust to changing demands in the market place gives them an edge over others.
In the last six years, the Pakistan government has created an enabling environment to help the industry operate efficiently in a liberal and deregulated environment. Unless the labour laws, (legislated in a nationalisation era) also conform to the changed environment, the cycle of reforms will remain incomplete. It is time to walk the talk.