Bank of Canada and European Central Bank raise rates

Dec. 7, 2005 The Folly of Rising Interest rates

Last week the European central bank raised its rate of interest by 1/4 % to 2.25 % despite the very high unemployment rates in France and Germany where unemployment is above 10 %. It did so despite pleas from leading politicians in Europe that it not do so and despite the fact that core inflation in Europe remains below 2 %.This is the first time that the central bank has raised its rates in the past five years and the first time it had changed the rate in the past 2 1/2 years.

The head of the Bank Jean -Claude Trichet insisted that the increase was a one off action that would not initiate a cycle of rate increases. Nevertheless, in the light of the high unemployment that grips France and Germany and the non-existant inflation outside of energy prices which are produced by a cartel and not by an over heated economy one has to wonder about the wisdome of increasing the bank rate. It demonstrates that the European central bank is still mired in the past and too inflexible to have caught up with the anti-inflationary reality of globalization and the severity of the unemployment crisis in Europe.
Here in Canada our Bank of Canada showed itself no more flexible and far seeing, although for the moment the unemploymentfront is far brighter than in Germany or France. Nevertheless where is the wisdom in increasing the rates when we have an opportunity to drive the unemployment rate below 6 % without inflation ? The current core inflation rate is 1.7 % and shows no sign of rising substantially. In fact the Bank's own data show that inflationary expectations -a nebulous term at best- are nowhere to be found.

Regrettably the Bank of Canada still operates with the discredited notion of the natural rate of unemployment set at 7 % whereby unemployment rates below this mark are thought to automatically trigger inflation or inflationary expectations. The evidence contradicts this claim and this theory. Its high time that the Bank did their homework. So long as the Federal government runs a surplus albeit a much smaller one the net effect is not overly stimulative.

There is more fiscal stimulation than in the past because of tax cuts and expenditure increases but the high employment budgetary surplus (setting the unemployment rate at 5 % and calculating the surplus or deficit at that rate with the current tax regime in place) means that overall the stimulus is not excessive even with relatively low rate s of interest.

The Bank of course presumes foolishly that 7 % unemployment is high or full employment. That explains why it argues there are inflationary expectations.

If the core rate of inflation is 1.7 % then the real rate of interest with a bank rate set at 3.5 % is still close to 2 %.Real rates are even higher when we look at bond prices and prime interest rates and credit card rates. Even at 86 % capacity utilization outside of the energy sector there is still no sign of inflationary pressure.

Globalization, free trade and the flood of impoirts and outsourcing labour and the very high Canadian dollar all together make for a powerful anti-inflationary force. It would be nice to think that the Bank's caution about its future prognosis is a sign they are getting the message. But so far actions speak loude r than words. Its time the central bankers went back to school and caught up with both economic theory and the nature of globalization.

Key words "Bank of Canada", "European Central Bank", "unemployment", "inflation", "bank rate", & "interest rates".