Volatility may be provoked

The Governing Council of the ECB decided to increase the key interest rates by 25 basis points to 1.5% on the 7th of July due to the high inflation in euro area. The annual HICP inflation was 2.7% in June 2011 that is inconsistent with the primary objective of the ECB’s monetary policy to maintain inflation rates below, but close to, 2% over the medium term. According to the introductory statement to the press conference such anchoring is a prerequisite condition to the economic growth in euro area. However, the ECB’s attempts to strengthen euro by increased key interest rates may evoke even higher volatility. The results of the EU wide stress test will be announced on Friday, 15 July. Moreover, participants of the financial markets are sensitive to news those increase burden of the “peripheral” countries to manage their debts.


According to the EU wide stress test scenario based on the ongoing EU sovereign debt crisis, the domestic demand of the euro area will decline affecting consumption and investment. It is assumed that the long-term interest rates will go up by 75 basis points, stock prices will fall by 15%, house prices will decline, tensions regarding the European money market will renew and contribute to an increase in short-term interest inter-bank rates by125 basis points. Considering the scenario which involves global negative effect of the US policy and a USD depreciation vis-à-vis all currencies, the private consumption and investment will be getting worse; however, it is assumed that both oil and non-oil commodities will be unaffected and the monetary policy will be unchanged. Considering the circumstances mentioned above it is anticipated that the overall effect of the EU-specific and external environment shocks will reduce the GDP growth by around 2% in both 2011 and 2012 and HICP will be lower by 0.5 and 1.1 percentage points for the euro area.

Although the ECB expects that the increased interest rates will reduce inflation and contribute to enhance economic growth, higher energy and commodity prices those are the main reason of the increased HICP little can be changed by such decision. Moreover, when the increased interest rates are used to reduce monetary liquidity and at the same time the opposite actions such as emergency liquidity to assist banking system in the event of crisis are considered it leads to higher volatility in the financial markets. Thus, I wish the ECB was able to identify though was not following the anticipated negative scenarios of the EU wide stress test.