7th September 2008The Malta Independent on Sunday
This week the two main central banks in Europe both decided to leave their key interest rates unchanged, in spite of accumulating evidence that both the euro area and especially the UK are seeing their economies gathering speed in their slide into recession territory.
This accelerating deterioration in the macroeconomic environment of both the euro area and the UK is reflected in their respective rates of exchange which following substantial gains against the US dollar are seeing the trend reversing. The euro, which had come within a whisker of US$1.60 for every euro as recently as mid-July 2008, has retracted to around US$1.42 at the time of writing. An 11 per cent drop in the short space of seven weeks is well beyond the norm, even in the volatile foreign exchange market. Sterling also lost 12 per cent against the dollar in the same seven weeks and is down 16 per cent against the dollar from its high point last November at US$2.10 for every pound sterling.
The message being delivered by these wild foreign exchange movements is that the market believes that the US economy is just about hitting bottom and can be expected to start growing again pretty soon, which would force the US Federal Reserve Bank to start increasing interest rates. On the contrary, the economies of the euro zone and the UK have to slow down much further and their respective central banks will have to cut interest rates as soon as the economy starts sending signals that it is running out of steam with rising unemployment and falling inflation resulting from the retraction in price of energy and commodities. The prospect of higher interest rates and economic growth in the US and lower interest rate and recession in UK and euro zone is the prime mover of the wild foreign exchange movements we are witnessing.
The obvious question is why, in the face of this unmistakeable trend, have the European Central Bank (ECB) and the Bank of England (BoE) not cut interest rates even now in order to accelerate the rate of exchange adjustment and place a cushion to protect against the pain of a hard landing of their economies.
The simple answer that the current level of inflation is too high to allow space for monetary loosening is too simplistic. Monetary loosening will at best impact on the real economy with a time lag of between six to 12 months. Consequently, central banks making their current interest rate decisions have to take account of what inflation will be six months to 12 months down the road rather than where current inflation stands. With oil prices falling from a high of US$147 per barrel in mid-July to about US$106 at present and commodities prices plummeting across the board, there is pretty little doubt that headline inflation will witness a dramatic decline over the next six to 12 months.
What central banks are less confident about is how core inflation will behave over the same period. Core inflation is headline inflation after it is stripped of the energy and food components. Core inflation is meant to measure how much the price movements in energy and food (which are largely imported and cannot be influenced by domestic monetary policy) are being transmitted across the whole economy through second and third round transmissions as producers pass on increases in energy and commodity costs through increased prices for manufactured products and services.
With the UK economy materially dependant on real estate/construction and financial services, there exists a more clear-cut case about the risk of recession in the UK and why the GBP sterling has lost so much value since last November. BoE is clearly more disposed to contemplate interest rate cuts than the ECB. While members of the BoE monetary policy council expose divergent opinions, ECB members seem to speak with a unified hawkish voice, shooting down any suggestions to contemplate interest rate cuts and, if anything, indicating that they can consider further interest rate increases following the quarter point increase delivered last July.
To justify its hawkish stand in the face of accumulating evidence of a euro area-wide economic slowdown, Jean C. Trichet (president of the ECB) insisted that a tight monetary policy was needed to ensure that inflation expectations remain in line with the ECB objective of having inflation below but close to two per cent. Institutional arrangements of wage indexation in the euro zone are still in existence, which make it far easier than it is in the US or UK, for headline inflation to be transmitted to second round price increases that would affect the entire economy. Trichet made an appeal for such institutional automatic inflation wage adjustments to be abolished.
The clear implication is that such mechanisms are keeping the ECB from lowering interest rates. This means that automatic inflation wage adjustments come with a considerable cost to macro economic growth and higher mortgage interest rates. In simple language, he is warning the unions that their resistance to dismantle such mechanisms will cost more than they gain. The automatic wage increases will slowdown the economy, thus reducing opportunities for overtime and better employment and, as most workers are homeowners with a mortgage, whatever wage increases they get are more than neutralised by higher mortgage payments.
Because of our COLA mechanism, Malta is one of the countries Trichet was addressing and in so doing he made similar recommendations proposed recently by the IMF. Modesty apart, I have been making such suggestions for several years, firmly believing that the COLA mechanism introduced in 1990 has outlived the usefulness of its purpose.
We are not the worst offenders as our system is one of partial indexation; other countries like Cyprus have a more dangerous system of full indexation. The government scoffed at the IMF’s suggestions and seems reluctant to take on the ECB’s advice, arguing that the partial nature of our system limits the damage and procures industrial stability.
Frankly, I believe that pressure for dismantling the COLA mechanism should come from the unions. In the long run their workers are getting nothing but are endangering the stability of employing organisations in the process. If a COLA is given in the next budget of e3.50 which after tax at say 15 per cent reduces to about e3 per week, it does not go far enough to pay for a mortgage of say e100,000 on which COLA is keeping interest rates one per cent higher than they should be, costing e1000 p.a. equivalent to e19 per week.
Lower interest rates will protect better the value of workers’ residence and financial investments and, above all, will make employing organisations more competitive, stimulating investments and creating new employment opportunities that pay better wages and salaries. It would also allow unions to negotiate wage increases at one point only, i.e. in collective agreements, and remove the perception that the COLA is being provided by government. This will help ensure that wage increases are related to productivity gains in the respective employing organisation. To protect non-unionised employees, COLA could be replaced by annual legally enforced increases to the national minimum wage.
It is time for COLA to be revisited and the time to do it is now. What is not done in the first years of a legislature becomes almost impossible to address in later years!