The Reaction of the Markets to the Step of ECB to Raise Interest Rates - Term Paper Example

On the first of December of 2005, the European Central Bank raised interest rates to 2.55 %.; in spite of the fact that it was a predictable step (especially for those who believed that the level of inflation in Eurozone must be tackled) it nevertheless caused some concerns for those who hold the belief that ECB should not take this measure in view of the sluggish economic growth in European countries. The reaction of the markets to this step of ECB was hardly typical as the shares prices rose and euro declined against the dollar within several days after announcement about the rising of the interest rates had been made (However, the reaction of American markets was more typical one as the Dow Jones Stock Index of 600 major European companies fell by 2 points within the several days after the announcement had been made). According to the monetary theory, the reverse effect should have taken place- the prices of the bond should have been decreased, whereas euro should have appreciated. However, this reaction can be explained by the fact that Mr. Trichet-the president of ECB reiterated that the latest move of the ECB should not be treated as an indication of the policy of high interest rates. The reaction of the market that followed can be explained by the confidence of investors in more cautious approach of ECB, as the appreciation of the Euro ceased after new announcements of Mr. Trichet. After all, there is little doubt that the financial experts of ECB do not realize that high interest rate of ECB which might entail appreciation of Euro and tightening of available pools of credit may hamper economic growth in European area. This step can be viewed as an attempt (apparently temporarily) to combat high level of inflation. It is too early to say whether this decision will seriously affect economic growth in European countries. According to OECD, the raising of interest rate could wait until the middle of 2006 when more robust economic growth is expected. However, countries of EU differ in economic, financial and political terms, with weak growth in Germany and France and stronger one in Spain and Ireland; after Maastricht agreements none of the countries mentioned has the opportunity to regulate the growth in the country by traditional methods of money supply. Overall, the economic growth in the European countries was less than in the USA (4.3% in the USA against 2.6% in the countries of European Union) and it affected major industrial nations of the EU. If the trend of appreciation of the Euro currency continues, it may hamper export- one of the vital elements of economic recovery in European countries and reduce long term competitiveness of European companies. Previously market reacted according to well-known monetary theory when the prices of the assets (such as bonds and shares) moved in the opposite directions of the changes in the interest rates. However, one should not forget that in 2003 when the ECB reduced interest rates to one of the lowest points in history of EU (2%) euro appreciated rather then depreciated (this movement of currency was partly due to more active measures taken by FRS of the US). In this case the inflationary threat was not so great and it was clear that the bank took this step to stimulate the growth in EU area. In spite of the fact that two years have passed, ECB faces the same task today. Investors in the market tend to believe that the long-term strategy for ECB will be conducting less restrictive monetary policy in 2006. In my opinion the step taken by ECB was not anticipated in the middle of the year 2005, however it was anticipated several weeks before the announcement had been made. According to the annual report of BIS, published in June of 2005 the threat of inflation in European countries was not great (even if the prices on the oil were taken into account). The major points of concerns however were house prices increases as well as the steadfast increase in the credits. According to Economist magazine, there were plenty of activists who urged ECB to take more proactive and less restricting monetary policy stance. With high exchange rate of Euro, which hampered export, coupled with comparatively slow economic growth ECB could have taken other steps in monetary policy decisions- this view was hold by many in the summer of 2005. Several days before the announcement was made several bankers as well trade unions and eminent business representatives predicted that high interest rates would slow down economic growth and would increase unemployment. The increase in interest rates according to this group was not timely. Yet, as the annual rate of inflation reached 2.4% in November (even if the rate was less than inflation rate of September with record high level of 2.6%) ECB decided to take more rapid steps to control inflation. Further actions of ECB depend on the level of inflation in European countries. There are reasonable grounds to believe that if the level of inflation is above the targeted level (2% in EU area) the ECB, may increase interest rates again. This scenario may materialize if the prices on the oil continue to rise. The reaction of the market however, was largely due to the fact that ECB would have no option but to accommodate its policy to the existing problems of the growth in EU area. This reaction was produced by further comments of Mr. Trichett, rather than by the anticipations of investors. However, in my opinion if this move was not anticipated (and there were some indications that the increase in rates was a settled policy of ECB and no comments from bank's representatives to the contrary) the reaction would be typical- Euro would appreciate further and the prices of the assets would decline. In light of the economic differences among several nations of the European Union, it is very difficult for ECB to formulate effective monetary policy for all the countries of the area, thus currently it focuses on one aim - to control the inflation. In the opinions of many experts one could hardly blame ECB for the staggering economic problems of EU countries as most of them have been entailed by the failure of the European countries to increase competition in the services, reform labor market in order to increase mobility between the nations and other structural social problems of the nations. If these problems are resolved in the nearest future, then the growth in Economic area will resume even with limited help of ECB. On the six of December, Bank of England decided to maintain its current interest rates on the level of 4.5%, as the growth of British economy was quite strong (especially in the business sector) and sustained by the high consumer confidence and comparatively low level of inflation. However there are some concerns that the current growth might slow down and several of investors held the belief that the current rate should be reduced. Thus the reactions of the markets to the announcements were different as there was no volatility of the British pound after the announcement had been made and no clear reaction of financial markets. This was largely due to the fact that this move was predictable and even as it disappointed some of the analytics it was viewed as the measure to reduce the threat of inflation in the UK. Works cited. Trichet's dilemma, The Economist, Dec 2, 2005. Sara Calian, Higher Interest Rates May Hurt European profit Growth; Moves by U.S Fed, ECB Put a strain on Earnings and Europe's Stock Rally, Wall Street Journal, December 6, 2005, p.C.14. Dave Shellock, Contrary investors send bourses soaring after ECB raises rates GLOBAL OVERVIEW; Financial Times, December 2, 2005, p.26 Joanna Chung, Jennifer Hughes, David Turner, ECB inspires eurozone rally GOVERNMENT BONDS; Financial Times, December 2, p.43. Read More