ECB must tighten now to avoid sharper correction later

Lifting interest rates from negative levels would correct past errors

Independent central bankers are not known for taking undue risks. But what happens when they misjudge sharply rising inflation rates and fail to live up to their mandate? Then problems threaten to become uncontrollable, and confidence in the monetary authorities and the currency will suffer.

The core mandate of the European Central Bank is to ensure a stable price level. However, the governing council has grievously neglected increasing signs of a prolonged and unacceptably higher inflation that could become self-reinforcing.

In recent months the ECB has reached an impasse. It is now time to reverse gear. On the one hand, the ECB is sending signals to the markets, governments and the public that it will keep interest rates at zero or negative levels for several years and continue bond-buying-programmes, even after its pandemic emergency purchase programme expires on 31 March.

On the other hand, it faces high inflation, which requires monetary policy action that would hit highly indebted euro states. The ECB has manoeuvred itself into a predicament from which it will be difficult to escape without damaging credibility and trust.

It failed to take the opportunity in 2017-18 to withdraw from its ultra-expansive policy. Now it has compounded the error by misdiagnosing inflationary pressures and underestimating their persistence.

As early as 2014, the ECB took aggressive action to introduce negative interest rates to counter the risk of deflation, which never existed in the manner it alleged. Instead of admitting its mistakes, the ECB used every phase of crisis to venture ever further into unknown territory, lowering interest rates further and inflating the balance sheet to unimagined dimensions.

The ECB became the first major central bank to operate negative interest rates. The Federal Reserve and the Bank of England shunned this move for good reasons, on the grounds that negative interest rates are a ‘destructive mechanism,’ in the words of Richard Fisher, former president of the Federal Reserve Bank of Dallas.

The ECB needs urgently to correct the 2014 error and bring the deposit rate out of negative territory. In addition, it could rectify its second misdiagnosis of regarding rising inflation as temporary. The ECB has forecast that inflation will decline as the temporary factors unwind. And it has denied any reason for taking monetary policy measures, which anyway work only with a delay.

This reasoning is not without foundation, but the analysis falls short. Monetary decision-makers need a comprehensive understanding of the economy and years of experience to identify potential price risks and to discern their transitoriness or permanence. Slavishly and exclusively relying on economic models for inflation projections places insufficient weight on the dynamics and interaction of economic processes.

In fact, inflation and growth projections are just one input. Decision-makers need to include other information in weighing possible action, examining its proportionality and integrating their own judgement, based on experience and economic understanding. The ECB’s current decision-making processes seem to neglect these latter factors

Today’s inflation rates reflect the past and – for the time being – have no bearing on the future. The reaction of the central bank is crucial in determining whether higher inflation persists and feeds into higher inflation expectations.

Admittedly, there are few signs that higher price levels are leading to higher wage claims, which might threaten a wage-price spiral. This might bolster the case for inflation being temporary or for confidence in the central bank’s willingness and ability to prevent inflation escalating. However, it is naïve to assume that a prolonged period of high inflation would not affect future wage settlements.

Fiscal and monetary policies seem likely to remain extremely expansionary. Euro area M3 money supply has increased significantly during the pandemic, with the Eurosystem’s balance sheet now more than 70% of euro area gross domestic product. Real interest rates are at an economically unacceptably low level of more than minus 5%. In view of high central bank balance sheets, if inflation hardens in coming months, fighting it with gradual interest rate increases and a cosmetic correction of balance sheets will be ineffective.

In addition, structural factors suggest persistently higher inflation, including measures to mitigate climate change. The ECB now sees itself as an actor in climate mitigation, but it must heed its mandate. If climate policy leads to higher inflation, the ECB will have no choice but to take countermeasures.

Forces behind disinflation over the past three decades, namely demography and globalisation, are being reversed. The shrinking of the workforce and incipient deglobalisation through shorter value and supply chains are likely to lead to higher prices in the longer term.

All this suggests that, if central banks do not act, decades of price stability will come to an end. Yet the majority of the ECB’s council finds it difficult to change course, because that would break its ‘forward guidance’ of keeping interest rates at current negative levels for a long time, or even to lower them further.

The council’s behaviour demonstrates a 30-year pattern of asymmetry in leading central banks’ monetary policies. At times of weakening economies and declining inflation, central banks have tended to cut interest rates aggressively. But when economies recover and inflation rises again, they hesitate to raise rates, or lift them only in small doses.

The ECB council finds repositioning difficult. The ECB is under fiscal dominance. It is openly operating monetary government financing through government bond purchases. These are the facts, even if the ECB justifies its actions by pointing to disruption of the monetary policy transmission mechanism (however defined) and its intention to keep financing costs low.

There is anticipation of the impact of monetary policy decisions on debt servicing and public debt sustainability in many euro area countries. This is delaying necessary fiscal and monetary policy corrections. Highly indebted countries welcome higher inflation because it reduces the burden of government debt. But that limits the ECB’s ability to fulfil its core mandate.

The ECB’s errors and hesitancy can durably damage confidence in both the central bank and the euro. The ECB needs to change course to avoid confirming an impression of negligence and irresponsibility. It must show it takes its core mandate seriously. If the ECB continues to hesitate and inflation remains high, a situation may develop where a policy of appeasement is no longer accepted. That would require, subsequently, a much sharper policy correction.

Jürgen Stark was Bundesbank Vice President in 1998-2006 (and acting president for a short period in 2004) and was a member of the ECB executive board in 2006-11. This is an edited translation of an article from Die Welt.

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