It all hangs on Wim's whim

The European Central Bank is between a rock and a hard place. Should it keep interest rates on hold while all about are cutting theirs in determined pursuit of the holy grail of price stability? Or should it make a friend of the trend and, in line with other central banks, cut rates as its contribution to the global battle against recession?

Yesterday, despite the hopes which had been building up in the financial markets and which the bank had, arguably, been encouraging, it opted to do nothing. Whether the policy should be put down as masterly inactivity or worried indecision is not clear. Not that such considerations bothered the foreign exchange market. No news was not greeted as good news. Dealers promptly dumped the single currency - pushing it down to its lowest level this year.

Rapid reaction


Nor is the ECB off the interest rate hook. Expectations have simply switched to the pre-Easter meeting on April 11. Yesterday's response from the forex market's rapid reaction force was a warning to the bank's president, Wim Duisenberg, of what will happen if he fails to deliver in two weeks' time.

For the markets and many analysts, the ECB's policymaking should be a breeze. The US has slowed sharply - at best. Japan is mired in recession. Equity markets have a white-knuckled look about them. The numbers from parts of the eurozone don't look too bad but Germany - the biggest bit - is heading for the doldrums.

So, get on with it - cut rates, boost growth prospects and watch the euro rise. Forget inflation. The global slowdown and a stronger currency will take care of that.

Yet as Mr Duisenberg sits in his eyrie in the ECB tower in central Frankfurt, puffing on the inevitable cigarette, the choice is not quite so easy. When the idea of the single currency was sold to both the international investment community and to the citizens of the 12-nation single currency zone, nobody discouraged the belief that the euro would be a clone of that then favourite of the forex market - the German mark.

The snag is that the impression has stuck. When investors want a view on the eurozone they tend to look at Germany. The view is not encouraging.

Little wonder that the euro fell from $1.17 to little more than 80 cents in less than two years. Or that the subsequent 15% rally on the back of a bombing US economy ran out of steam the moment the US Federal Reserve cut interest rates. At not much over 88 cents, the euro is starting to resemble the Grand Old Duke of York's army - marched all the way up to the top of the hill, only to be marched back down again.

Secondly the ECB's central mandate is not to foster growth, it is to keep the lid firmly on inflation. True, interest rates can be set with a view to supporting the general economic policy of the eurozone - but not at the price of jeopardising price stability. Though there is a reasonable expectation that inflation will head down it is still some way north of the ECB's 2% ceiling. The ECB's favourite monetary aggregate, M3, is hardly pointing the way to lower rates either.

"If the decision was a close call, probably the anxiety over inflation levels and the M3 growth number won the day," according to Bernard Walschots at Holland's Rabobank.

The bank has a longer term agenda. It has argued that countries within the eurozone need to embrace structural economic reforms. There are signs some heed is being paid but the pace of change is scarcely break neck and is unlikely to pick up speed if the ECB shows it is prepared to let interest rates, rather than reform, take the strain.

There are political complications, too. The European Commission president, Romano Prodi, yesterday argued: "The ECB must be independent but must not suffer from loneliness. Europe now lacks strong political structures because national states do not want to create them.

"In the United States [Fed chairman Alan] Greenspan feels the vibrant politics that surrounds him. He keeps his independence but has next to him strong political institutions.

"The trouble is that no-one wants to believe that the ECB is independent... and there is a view that the United States is a giant and Europe a dwarf. But future events will dispel this impression."

Quite whether Mr Duisenberg would feel comfortable surrounded by "vibrant politics" is an interesting question. But he would doubtless feel happier if national politicians showed greater willingness to coordinate their fiscal policies with the ECB's monetary one.

There may be arguments for suggesting that Ireland is a special case but the ECB must be looking at some of the promises being made in the Italian election campaign and wondering quite how they square with the eurozone's stability pact which is meant to keep budget debt and deficits in line. But then politicians have elections to win.

Nor do the politics stop there. In nine months' time the 12 countries of the eurozone will have to give up their national currencies in favour of euronotes and coins. The change over must go well. A political generation in Europe has staked its credibility on making the euro work.

Yet as the value of the euro rises, or more often, falls according to the whim of the foreign exchange market, Europe's savers are tending to the sceptical. The ECB needs to be able to demonstrate that it has at least some control over the external value of the single currency.

Harold Wilson's "the pound in your pocket has not been devalued" style of argument cuts little ice even if, in a near closed economy like the eurozone, they have some merit.

Cartoon character


The ECB may be rescued by the dollar, finally losing favour with investors. It seems hardly credible that the greenback can continue to be the world's reserve currency while the US is running a current account deficit of 4.4% of GDP and share values are plummeting. Like the cartoon character who has run over a cliff and doesn't realise he's suspended in midair, sooner or later, the dollar is going to fall.

What matters is whether this will happen soon enough to rescue the ECB from its dilemma and whether the bank can persuade its two constituencies - the world's financial markets and Europe's citizens - that it always knew it was going to happen. In short that it was Wim's whim, not that of the forex market.