Falling back on orthodoxy

Within hour of Portugal asking the European Union to bail out its financial system, Jean-Claude Trichet, the head of the European Central Bank (ECB), on Thursday announced a 0.25-percentage point increase in interest rates, raising its key lending rate to 1.25 percent, and putting an end to 23 months of a monetary-policy stance coherent with a situation of recession in several euro-zone countries. He suggested that further hikes were likely in the medium term.

The ECB's decision is inopportune, above all because further financial turbulence (as evidenced by Portugal's call for help) is likely, while many countries are still unable to get their economies to grow. But Trichet is guided more by politics: France and Germany, are now back on track, with their economies registering growth. Monetary policy can now adjust to this reality (measures to facilitate liquidity will be maintained) without endangering these two countries' activities.

Trichet has his reasons for applying tougher monetary policies. Recent months have seen tensions over the prices of raw materials. For example, oil and food: the rise in the price of wheat is a key factor in the uprisings in North Africa. Oil is now close to $120 a barrel, which will see a medium-term increase in the price of crude for the rest of the year. Unless we see a rapid fall in oil prices in the coming months, this could push inflation up via wage increases. What Trichet calls "second-round effects" are a risk.

The forcefulness with which the ECB's chief has outlined his arguments suggest that the decision to hike interest rates was the direct result of a return to orthodoxy. "All central banks, in periods like this where you have inflation threats that are coming from commodities, have to go through the hump and be very careful that there are no second-round effects," Trichet declared in an interview earlier this year with the Wall Street Journal.

That said, the question now is whether it is possible to balance preventative anti-inflationary measures with monetary policies that do not slow down the recovery of countries still unable to grow and create jobs in the process. In Spain, costlier money will use up the income required to stimulate consumer spending, and could increase further the number of bad loans that banks have on their books.

Trichet could have found that balance if he had been more detailed about when the next interest rate hikes will be, and by how much the cost of borrowing will continue to increase. Governments, consumers, and business are all calling for a well-explained and well-managed monetary policy.

If the cost of borrowing has to increase, it should be done over stages in small doses. But Trichet was vague on this, hiding behind formulas such as: "we will continue to adopt decisions that will stimulate price stability." With Greece, Ireland, and now Portugal all in intensive care, his words are less than reassuring.