European central bank raises rates 25 basis points

June 7, 2007

With overall inflation as measured by the CPI running at 1.9%, unemployment at 7.1 % down from 7.2% last month and a gross debt to GDP ratio of 70 % the Europen central bank yesterday raised its key lending and deposit rates by 25 basis points. This albeit cautious tightening of monetary policy at a time when France is trying to lower its unemployment rate and Germany still faces relatively high unemployment seems like a perverse dogmatic decision by the Bank.
Overall unemployment of over 7 % is clearly far too high for this rate to be enshrined as some sort of natural rate of unemployment. The Bank would be much better off and the European public as well if they pay attention to the notion of the natural rate of inflation . I define it as that rate of inflation below which you tend to get chronic or accelerating excessive unemployment. I suspect that this where Europe is currently stuck.

Tolerating slightly higher inflation targets say 3-3.5 % would permit substantially lower interest rates and lower unemployment. In addition the disinflationary impact of globalization and the Japanese deflation ought to be factored into the ECB's central equation.