ECB raises interest rates, but should have let them be

ECB has pursued inflationary policies in the past, but this move may be a deflationary one

Alex Domanski / Reuters
A sculpture showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt April 7, 2011. The bank's decision to raise interest rates was a mistake, writes guest blogger Stefan Karlsson.

This may surprise some readers, since I am normally very "hawkish", but I believe that today's ECB interest rate increase is a mistake. The reason for that is that while inflationary policies are bad, so are deflationary ones. And this is clearly a deflationary move.

Even before this interest rate increase, money supply growth has become virtually flat and in fact slightly negative., with annualized M1 growth being -0.8% during the latest 6 month period. This interest rate increase will likely push it further into negative territory.

Not surprisingly given this fact, the euro has increased in value this year by as much as 8% against the U.S. dollar. While this in part reflects general U.S. dollar weakness caused by QE2, it also reflects the current deflationary euro area conditions, as the euro has appreciated against almost all currencies (with one exception being the Swedish krona, as the Riksbank is also pursuing deflationary policies).

Yet even as the euro exchange rate is soaring, bond yields are also rising especially in troubled countries, also suggesting deflationary monetary conditions.
It is true that prices of many commodities have risen, even in terms of euros. Yet that reflect foreign (manily Fed) monetary policy and negative supply shocks like the war in Libya.

The increasingly deflationary monetary policy is one partial explanation for why Portugal was forced to seek an EU rescue package similar to the ones that Greece and Ireland have gotten.

The ECB has in the past pursued far too inflationary policies. It now risks erring in the opposite direction.

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