A Hawkish ECB

The European Central Bank (ECB) is a strange animal. It's one of the world's largest central banks and in charge of monetary policy for the twelve member countries of the Eurozone. Many liken the ECB to the Federal Reserve in the US. But there are significant differences.

The ECB is adherent to an "inflation target", which means policy is set according to the level of inflation expectations in the Eurozone—currently the target is 2%. (By contrast, the Fed has a dual mandate in managing unemployment and price levels.) Generally, the ECB will raise interest rates (shrink the money supply) when Eurozone inflation is above 2%, and lower interest rates (increase the money supply) when it's below 2%. This is unlike the Fed, which has the freedom to raise or lower interest rates according to what it believes is appropriate—not according to an arbitrary target.

Second, the ECB must take into account the fiscal policies of the twelve separate countries it represents. With such rich diversity in economies throughout Europe, a generic standard set by the ECB for the entire Eurozone can produce more of a political farce than an appropriate monetary policy.

It's for these reasons the ECB finds itself in something of a bind today. Inflation is expected to be above the 2% target in the coming months in Europe, but economic growth is stagnant and negative in some regions. So, to raise rates could lessen inflation, but it will also probably stifle what little economic stimulus there is left in Europe. As of today, the ECB appears committed to raise rates on December 7th, and market futures indicate about a 75% chance of at least one more rate hike in 2007.

This situation has raised flags amongst many economists and analysts. Could the ECB's rate hikes kill the European stock rally? Is it really appropriate to further choke off the money supply as France (one of the largest representatives of the EU) reports negative GDP?

Maybe, but these rate hikes are already expected, meaning they'll likely have no surprise power to affect markets when/if they occur. Additionally, we've noted often in this commentary the importance of a global perspective. Global liquidity growth is still positive. Nonetheless, it's a situation worth keeping an eye on as 2007 approaches.