Despite its often tough rhetoric, the ECB governing council's approach to setting monetary policy is, in fact, quite pragmatic, writes Alan Ahearne.

The ECB made the right decision yesterday. The unanimous decision to leave interest rates unchanged shows that despite the ECB's often tough rhetoric, the governing council's approach to setting monetary policy is, in fact, quite pragmatic.

Of course, the ECB's primary goal is to maintain price stability in the euro area over the medium-term. This means keeping inflation below but close to 2 per cent.

But in practice the ECB rightly also puts weight on stabilising the real economy, so long as doing so does not pose risks to price stability.

Only a little over a month ago, the case for a rise in interest rates in September seemed overwhelming. Inflation was running at just below 2 per cent and price pressures were increasing amid a strong economic recovery in the euro area - especially in Germany. On August 2nd, ECB president Jean-Claude Trichet told reporters that the central bank was exercising "strong vigilance" in the face of inflationary risks - ECB code words meaning a rise in interest rates is imminent.

But that was before the crisis that has hit international financial markets. The ECB yesterday had to make a judgment about how much damage the turmoil in credit markets is doing to the economy.

What the bank told us, in effect, is that it is too soon to tell.

The ECB did trim its growth forecast for 2007 and kept unchanged its forecast for 2008. But those projections are largely technical exercises produced by the ECB staff. They do not necessarily reflect the views of the Governing Council. Moreover, even if the baseline forecast for growth and inflation remains unchanged, the downside risks to that forecast must surely have increased markedly over recent weeks.

For starters, although we don't know how extensive the crisis in credit markets is going to be, we do know that several financial institutions in Germany have already been affected by the credit crunch. Other European banks may also be badly exposed.

Second, even if money markets settle down over coming months, credit to companies and households may not be as easily available as in recent years. This could slow business investment and spending on housing.

Third, the risks of a recession in the United States have increased significantly as a result of the deepening slump in the housing market there. A serious downturn in the US would hurt Europe's exports, in part because the dollar would probably decline against the euro.

In addition, it remains to be seen how the ongoing turmoil in financial markets has affected business and household sentiment across the euro area.

There are other reasons why a hike in rates yesterday would have been the wrong decision.

Financial market participants were not expecting the ECB to lift interest rates. Given the fragility of markets at present, a hike could have triggered another sell-off of shares and a further tightening of credit conditions.

As a general rule, central banks should only surprise financial markets if they have a good reason to do so. In addition, pushing up short-term interest rates would probably have resulted in a flattening in the yield curve, which would have hurt profits in the banking sector. Another blow to confidence in banks may have worsened conditions on the inter-bank market.

A hike would also have increased uncertainty about the ECB's intentions and created confusion about its likely future response to the crisis.

After all, why inject massive amounts of liquidity into the banking system on Wednesday and then tighten monetary policy the very next day?

None of this is to say that we are necessarily at the peak of the interest rate cycle. But as things stand, I can see little downside to waiting a month or two for calm to return to financial markets, and for more data on how the real economy is responding to the abrupt re-pricing of risk. The ECB should not be in a rush.

• Alan Ahearne is a former senior economist at the Federal Reserve Board in Washington DC. He lectures in economics at the Cairnes School of Business and Public Policy at NUI Galway.