ECB ready to raise rates but not the Fed

The European Central Bank looks set to raise interest rates soon. Don't expect the same from the Federal Reserve though.

On Thursday, ECB president Jean-Claude Trichet said at press conference following a monetary policy meeting that while it had left interest rates unchanged at the meeting, "[s]trong vigilance is warranted with a view to containing upside risks to price stability". He also told a reporter that "an increase in interest rates at the next meeting is possible".

While an increase in rates is mentioned by Trichet only as a possibility, history shows that once he talks about strong vigilance on inflation, a rate increase at the next meeting is in fact likely.

It may seem strange that, with some governments in the euro area already facing rising yields for the securities they are issuing, the ECB is actually considering a rate hike.

Many people will remember that the last time the ECB raised interest rates was in 2008; that rate hike turned out to be a mistake. Then, as now, oil and other commodity prices were rising rapidly, seemingly threatening a serious bout of inflation. However, the deterioration in credit markets that was ongoing in the United States at that time eventually turned into a full-blown international financial crisis that brought economic growth and inflation to a halt.

Today, we have the ECB contemplating another interest rate hike in the face of rapidly rising commodity prices while the market for European sovereign debt remains in some distress.

Despite the eerie parallel, the euro area's financial markets and economies are likely to be able to withstand a rate hike from the ECB better this time around. Trichet said that monetary policy is currently "very accommodative" which "lends considerable support to economic activity". A rate hike would likely only make monetary policy less accommodative, not outright restrictive.

The ECB's main refinancing rate, currently at 1.0 percent, has been well below the inflation rate since early last year and this is likely to remain the case even with a rate hike next month. The latest estimate of the inflation rate, for February, is 2.4 percent. This is above the ECB's inflation ceiling of 2.0 percent.

In contrast, the rate hike in 2008 came at the end of more than two years of monetary policy tightening. In the couple of years prior to the rate hike in July 2008, the ECB had kept its main refinancing rate constantly above the inflation rate. By the middle of 2007, the ECB rate exceeded the inflation rate by two percentage points even though inflation was still just below 2.0 percent.

The spread between 10-year euro area government bond yields and the ECB main refinancing rate also indicates that monetary policy is very accommodative. Today, the spread is well over 200 basis points. In contrast, at the time the ECB increased rates in 2008, the spread had shrunk to almost zero.

To some extent, the conditions seen in the euro area also apply in the United States, indicating that monetary policy in the latter is also very accommodative.

Like in the euro area, the Federal Reserve's federal funds rate is currently significantly below the rate of inflation based on the personal consumption expenditures price index.

The spread between 10-year Treasuries and the federal funds rate is also wide, about as wide as it was in 2004 when the Fed last began a tightening cycle.

There are two main differences between the euro area and US situations though.

The first is that unlike in the euro area, the inflation rate in the US is still lower than desired by its central bank. The latest available US PCE inflation rate was January's 1.2 percent. The inflation rate of the PCE index excluding food and energy was 0.8 percent. Apart from being only half the measured rate in the euro area, the overall inflation rate in the US is also below the Fed's longer-run target range of 1.6 to 2.0 percent. The Fed expects PCE inflation to stay around or below 2 percent at least until the end of 2013.

Secondly, and probably crucially, the Fed and the ECB do not share exactly the same mandates. The ECB focuses on inflation in setting monetary policy while the Fed has a dual mandate that requires it to maximise employment as well as stabilise prices.

Friday's employment report showed that the first of the Fed's goals has not been achieved. The unemployment rate stood at 8.9 percent in February. Although this is well down from its peak of 10.1 percent in October 2009, it is still well above the range seen for the past few decades before the last recession as well as the longer-run target of around 5-6 percent.

In fact, the Fed currently projects the unemployment rate to fall only gradually over the next few years and still be around 7 percent by the end of 2013.

As Fed chairman Ben Bernanke told the Senate Banking Committee last week: "Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established."

That suggests that the Fed will be in no hurry to remove monetary stimulus soon.