in contrast to european policy makers, Bank of England has tried to control asset prices
Policy makers at the European Central Bank (ECB) including president Jean-Claude Trichet and chief economist Otmar Issing are gambling that they will be able to contain surging property prices without derailing consumer spending, which accounts for half of the $9 trillion euro-region economy.
"As long as we do not see house prices coming down, those ECB members wanting higher rates will keep pushing for them," says Nicolas Sobczak, senior European economist at Goldman Sachs Group in Paris. "But the consumer is in disarray, so it does not mean they will win."
House prices in the 12 nations sharing the euro climbed by 7.7% in the first half of 2005, five times the rate of economic growth and double the average during the years 1997-2000, according to the ECB.
Trichet's willingness to use rates to target asset prices puts him on the other side of the debate from such policy makers as US Federal Reserve chairman Ben Bernanke.
"This issue is a big one, and central banks are divided,"says Adam Posen, a senior fellow at the Institute for International Economics in Washington.
Fed officials have adopted a hands-off policy, saying a central bank should ease the aftermath of burst asset bubbles rather than seeking to prevent them by raising rates.
Bernanke told the US Congress on 15 February that a "moderate softening" in US home prices is more likely than a "sharp contraction" after a record year for home sales in 2005.
In contrast, British monetary policy makers under Bank of England governor (BoE) Mervyn King have tried to control asset prices. The BoE cited the tripling of property prices over the previous decade when it began raising rates five times in the 10 months to August 2004.
Trichet, says policy makers remain far from agreement. While Issing says analysis may help identify bubbles in advance, Bundesbank president Axel Weber says that rates "are often too blunt an instrument to slowly let the air out of a bubble".
The ECB's latest monthly bulletin says housing overvaluation demands "continued vigilance".
Residential property prices recorded their fifth year of "strong dynamism" in 2004, increasing 7% following 7.1% in 2003. Between 1997 and 2004, Irish house prices almost tripled, and in Spain they more than doubled, according to Merrill Lynch.
An ECB analysis based on how much rental income properties could have generated over the past two decades showed home prices now exceed their historical average by between 15% and 25%.
Central bankers point to such data as a reason to be concerned that 2006 inflation may top the ECB's target of 2% for a seventh year.
Consumer prices rose 2.4% in January from a year ago, according to the European Union's Luxembourg-based statistics office. Policy makers also say the economy and financial markets may be in danger if borrowing goes unabated.
House prices rose 5.1% in December from the previous year, according to the EU's statistics office.
Of the major prices used to compile inflation data only those for energy gained more, increasing 11.2%. Overall, consumer prices rose 2.2%.
"The most important responsibility we have at the moment is not to allow the further inflation of the bubble itself," Trichet told the European Parliament.
Issing, says property price inflation is "unsustainable".
Thomas Mayer, chief European economist at Deutsche Bank says: "With recent house price developments posing a risk to future price and financial stability, we expect the ECB to continue its policy of a very gradual normalization of interest rates." He predicts rates reaching a four-year high of 3% by the end of the year.
Higher house prices typically fuel consumer spending by allowing homeowners to withdraw equity to fund other purchases or by encouraging sales of appliances and furniture. In Spain, consumer spending last year jumped 4.4%.
Conversely, expenditures by German households, where home values declined 2.1% in 2004, stagnated, prompting some economists to say that home values throughout the euro-area remain under control.
"The ECB has to look at the whole region. When you do that I do not think there is a major problem," says Dario Perkins, an economist at ABN Amro.
Plagued by an 8.4% unemployment rate and an 88% surge in oil prices in the past two years, consumer spending remains weak and higher interest rates may hamper it further, says Michael Dicks, chief European economist at Lehman Brothers.
The European economy grew just 0.3% in the fourth quarter from the prior three months as household spending in Germany's economy, the region's biggest, fell.
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