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There’s been little indication that the ECB has wavered from its intent to tighten rates this week, despite the deterioration in the eurozone sovereign crisis since last month’s press conference.    But is its resolve in (seemingly) pushing ahead to tighten rates a sign of confidence or recklessness?

There are growing signs that it may be the latter, although it could be some time before the answer becomes clear.

Guest post by FXPro

For now, the basic question is what is the link between the developing sovereign crisis and monetary policy?  Leaving aside the economic angle, it’s the financial risks that are more the immediate concern.  Unfortunately, the next ECB bank-lending survey is not due until the end of this month, but it was notable that the cost of funds and balance sheet constraints were the factors that increased most in the April survey as acting as constraints on lending to the household sector.  Given the patterns we’ve seen in money markets, and also the deterioration in the sovereign crisis, it’s quite likely that they will have acted as further constraints on the cost and availability of funds in the July survey.  In other words, lending conditions are likely to have tightened further, largely for reasons outside the ECB’s direct control.

But as well as actual developments, there is also the uncertainty surrounding current events.  Trichet himself admitted that the link between the banking sector and the current sovereign crisis was “the most significant threat to financial stability in the eurozone”.    Furthermore, we all know that monetary policy works with considerable time lags.  A year ago, EU leaders thought their actions would be sufficient to contain the sovereign crisis but that proved to be way off the mark.  Currently, there is little sense that they are ahead of the game but, by raising rates, the ECB appears to be betting that they are but they could well be proven wrong.

Simon Smith, Chief Economist