ECB endgame has governments thinking about rate hike damage

Frankfurt

EUROPEAN finance ministers and central bankers will gather in Vienna this week to discuss a key test for the eurozone's expanding economy - whether it can cope with interest rate hikes.

The debate reflects the currency bloc's relatively solid economic health after a decade of crises and recessions, but also marks a new challenge. The European Central Bank's (ECB) plan to gradually unwind years of extraordinary monetary stimulus comes with the risk of destabilising asset markets such as stocks and real estate if they are bloated by cheap money.

Higher interest rates could also cause problems for national governments, which have increased borrowing in the past decade. Total debt in the euro area stands at about 84 per cent of gross domestic product (GDP) this year, compared with 65 per cent in 2007, according to the International Monetary Fund (IMF).

Some countries have already sounded the alarm. The Bundesbank reckons that German homes are overvalued by as much as 35 per cent in major cities. France is concerned about high levels of corporate debt. Italy's populist government worries that the nation's bond market could be hit by speculators when the ECB pulls back.

"Our experience is that once there is a bubble, it's very often resistant to small interest rate increases," said Daniel Gros, director of the Centre for European Policy Studies, who will present a paper at the twice-yearly policy forum. "They're right, they should start thinking about it as a clear and present danger."

Mr Gros' paper concludes that higher interest rates "do not need to be the harbingers of wider financial market instability." In fact, continuing the policy of keeping rates low for a long period "might, over time, lead to a build-up of vulnerabilities".

For ECB policymakers, the question is: what is in their remit and what should be left to governments. Chief economist Peter Praet acknowledged last month that the central bank must monitor markets because stable consumer prices alone cannot ensure financial stability. Bundesbank president Jens Weidmann said that officials may need to tackle imbalances to prevent them from snowballing into a financial crisis.

But both men pushed back against the idea that the central bank should make financial stability part of its primary mandate alongside inflation, with Mr Weidmann saying that it might do more harm than good.

"There is no way in which monetary policy alone is capable of ensuring financial stability," said Claudio Borio, head of the Monetary and Economic Department at the Bank for International Settlements, who has urged policymakers to accept that the exit from easy money will be bumpy. "What you require is moving toward a macrofinancial stability framework, which includes not just monetary policy but also regulation and supervision, fiscal policy and even structural policies. You really need a package." BLOOMBERG