The ECB Wakes Up to Reality, Sort of

The ECB decided today to hold back from another interest rate hike. It seems the ECB has finally figured out that the series of interest rate hikes it intended to do this year probably would have caused the Eurozone some harm. Specifically, the ECB’s proposed tightening would have required more painful deflation in the Eurozone periphery to bring about the real depreciation that part of the currency union sorely needs. That much the ECB seems to understand. What they don’t seem to understand or don’t want to understand is that the periphery’s real depreciation could also occur through higher inflation in the core. That, however, would require the ECB to ease and allow more inflation in Germany, an unlikely event.

The ECB also hasn’t seemed to figure out that being passive is effectively keeping monetary policy tight. Nominal GDP remains well below trend, the Euro is surging, and the ECB balance sheet is slowing shrinking. Michael T. Darda appropriately calls these developments the caustic concoction brewing in the Eurozone. How much longer can this go on? If only the ECB would learn the lessons of the Fed’s passive tightening in 2008.

P.S. Be sure to see the recent pieces by Martin Wolf, Irwin M. Stelzer, and Paul Krugman on the Eurozone crisis.