How the ECB survived growing pains to make a name for itself

COULD IT really be true that the much maligned European Central Bank has been running its interest rate policy better than the Bank of England? That was the judgment offered last week by former Chancellor Kenneth Clarke. So far as the BoE was concerned, Clarke was being a bit harsh. Even it would not suggest that its performance has been perfect. But it has moved quickly to change course when fearing it had strayed on to the wrong path, so what mistakes it has made have been minor.

Arguably the turning point for the BoE came not, as Treasury spinners would have us believe, with the bright New Labour dawn of May 1997, but five years earlier in 1992.

Then the unlamented Chancellor Norman Lamont, casting around in the rubble of Britain's humiliating - but wise - retreat from the Exchange Rate Mechanism, decided he would follow little New Zealand's example of 1989 and give the Bank the job of meeting an inflation target. This, it was hoped, would help to lay a foundation on which to try to rebuild confidence in British monetary policy after almost 50 years of fumbling.

However, as Mervyn King, then the BoE's chief economist and now Deputy Governor, pointed out in October 1997, a fair assessment of the first five years of inflation targeting could not resolve the question of how much of the Bank's success in getting inflation down was due to its monetary policy and how much to a global trend towards seemingly permanent lower inflation. A bit of both, no doubt. But that still leaves the Bank looking good even five years further on.

So far as the ECB is concerned, however, the record is better than you might expect given the criticism heaped upon its president, Wim Duisenberg, and the problems it has had in convincing the world's financial markets of the wisdom of its approach. The most authoritative recent examination of the ECB's record is a far from uncritical review by a group of independent economists, published last month by the Centre for Economic Policy Research.

It argues that the ECB has passed its first big test, last year's economic slowdown, with flying colours. It was initially caught out by the US economic slowdown that started in 2000, and which hit Europe harder than it expected, and by an inflationary surge in oil and food prices, the CEPR says. But - high praise this - the CEPR concludes it reacted in much the same way as the pragmatic US Federal Reserve would have done if it had been based in Frankfurt.

The best support for this view is that in order to try to keep Euroland growing, the supposedly dogmatic and unimaginative ECB has had the courage to pay lip service to both of the 'pillars' on which it has been building its credibility.

As Danny Gabay of investment bank JP Morgan Chase points out, it lowered interest rates last year even though eurozone inflation had been running above 2% since late 1999 - supposedly the top end of its monitoring range. The M3 measure of money supply, its second pillar, has also been growing too fast for much of this period.

Taking risks with its credibility is not something the ECB will have enjoyed and there is a danger that it may have been taking one gamble too many. April's eurozone inflation figures due on THursday are expected to show a rise of 2.4% against 2.5% in March. It looks as if another year will pass with inflation above the level the ECB says is the top of its range. That, the markets are saying, must trigger a rate rise soon, even though healthy economic recovery in Euroland is far from assured.

So, in this respect, its critics have a point. Unlike the BoE, where the inflation target is set by the Chancellor, the truly independent ECB decided for itself on what rate goal it should have. The implicit target for the ECB would appear to be the mid-point of its monitoring range, namely 1%. If so, it has set itself goals which are uncomfortably close to deflation and too low to allow it the room for manoeuvre it really needs.

Perhaps it also needs to rethink its attitude towards the frequency with which it changes rates. Stability is all very well, but in a world characterised by increasing financial market volatility and the rapid cross-border transmission of financial market shocks, a greater readiness to move interest rates up and down may not be such a bad thing.

Were it indeed to raise rates in the next few weeks, as the market expects, the ECB would certainly have to lower them again if the dollar slumped. It needs to be prepared to explain and justify this. Nevertheless, on the evidence of its first three years, only its harshest critics would argue that the ECB is failing as an institution.