ECB Takes Away Punch Bowl

Today, the European Central Bank (ECB) raised its main refinancing rate by 0.25% to 1.25%.

Today, the European Central Bank (ECB) raised its main refinancing rate by 0.25% to 1.25%.

ECB President Trichet has long argued that its monetary policy is independent of the “extraordinary measures” put in place to support the financial system. However, it was only earlier this year that the market took Trichet’s suggestions that he may raise rates seriously, even as the sovereign debt crisis remains unresolved.

The role of a central bank is to take away the punch bowl when necessary, to pursue its mandate, not to be a cheerleader. The ECB’s move can be seen as a stern signal to the banking system and governments to get their act together. Ultimately, the fate of each individual nation is in that country’s hands, just as the fate of each bank rests with it’s respective management. The Eurozone as a whole, however, will not wait for local or corporate politics.

With regard to the banking system, a couple of banks this week have announced capital increases, including Germany’s second largest bank, Commerzbank. Trichet has previously urged, many times, that it “is essential for banks to retain earnings, to turn to the market to strengthen further their capital bases or to take full advantage of government support measures for recapitalisation. In particular, banks that currently have limited access to market financing urgently need to increase their capital and their efficiency.”

With regard to sovereigns, yields imposed by the bond markets appear to be the only language policy makers understand. It is rather impressive how much progress has been made – often by minority governments – in light of market pressures. As we have pointed out in the past, a quarter point rate hike may be the least of concerns for weak countries.

The tough love approach employed by the ECB is taking away the punch bowl. As a result, reform processes may be expedited. Trichet has pointed out in the past that the reward will be lower cost of borrowing and price stability in the future, key ingredients to long-term sustainable growth.

Axel Merk
President and Chief Investment Officer
Merk Investments, Manager of the Merk Funds