The highest inflation rate in the euro area since the introduction of the euro came as a shock to many. But was the jump to 7.5 percent in March really unexpected? Inflation dynamics have been evident since the summer of 2021, long before Russia invaded Ukraine. Even then, the European Central Bank (ECB) should have acted.
But she waited, wrongly assuming that the surge in inflation was temporary. At first it was only oil and gas that rose dramatically in price. In the meantime, price dynamics have become much broader and are hitting private households with all their might. So all the alarm signals should be sounding at the ECB.
Because a decisive factor behind this surge in inflation is the far too long phase of their extremely expansive monetary policy with negative interest rates, bond purchase programs and excess liquidity of 4.5 trillion euros. Although the economic environment repeatedly suggested it, the ECB has hesitated for years to exit this policy.
Now it’s about its core task, to fulfill which it was created: securing price level stability. And it’s about public confidence in the central bank and in the euro. So far, no convincing comment has been heard on how the ECB intends to deal with this situation. It still relies on the ECB staff’s inflation projections.
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They show inflation falling to 2% by the end of the projection horizon, in line with the ECB’s inflation target. So everything is only temporary and harmless? Not quite, because President Lagarde also speaks of a change in inflation dynamics compared to the pre-Corona period. So far there have been no consequences.
The ECB must take the public’s concerns seriously
In fact, several factors point to a higher inflation rate in the future. In the short term, the ECB’s hesitation compared to the US Federal Reserve will put pressure on the euro to depreciate. The consequences are rising import prices and higher inflation.
The disruption in supply chains and high transport costs will also continue to drive up prices. In addition, there are structural factors such as the inflation-driving demographic development or the recognizable process of deglobalization, which will continue as a result of the Ukraine war. Reshoring, i.e. the shortening or relocation of production processes and chains, will lead to higher costs, higher inflation and a loss of prosperity in Europe.
Nevertheless, based on previous public statements, the Governing Council of the ECB does not seem to be taking the consequences of the currency devaluation and the concerns of the population seriously or is simply ignoring them. The “normalization” of monetary policy was hinted at very cautiously with the bond purchases under the PEPP program which expired at the end of March, but which are partly offset elsewhere, and with possible, rather marginal interest rate changes.
The central bank will announce its future monetary policy course on Thursday.
(Photo: dpa)
The so-called “forward guidance” specifies the self-imposed sequence of decisions: first reducing the bond purchases, then increasing interest rates. However, the envisaged steps are totally insufficient in terms of sequence, speed and scope to slow down, let alone stop, the inflation dynamic. As price momentum persists and broadens, it becomes more entrenched and reflected in higher inflation expectations.
They will then inevitably affect wages and salaries. Because the trade unions will not be able to reassure their members with the argument that this is a temporary phenomenon in view of the current and expected price development and the standstill of the ECB. If the ECB does not act quickly and decisively, this will result in a wage-price spiral that can only be stopped with brutal intervention.
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The ECB completely underestimates this danger. If second-round effects show up and higher wages follow high inflation, she explains, this will only have a one-off effect. This argument is completely unrealistic.
Because excessive wage increases are not the end of a process, but lead to new inflation dynamics. Higher wages mean higher production costs, which are passed on to consumers in the form of higher prices, leading to even higher inflation. We then find ourselves in a self-reinforcing wage-price spiral.
The new inflationary momentum, which for the above reasons will not subside anytime soon, requires a sharp policy correction. The ECB must not freeze because of the dramatic geopolitical situation. It must not itself become an additional risk factor and neglect its mission.
It must now live up to its mandate and act as it did in the crises: quickly and decisively. A U-turn is needed, as is being done in politics for other reasons.
Communication by the ECB alone is not enough
Why isn’t she acting quickly and decisively now when it comes to her core mission? In crisis management over the past few years, she has ventured into uncharted territory. It kept lowering interest rates and launched new government bond purchase programs.
It has also acted on fears of misdiagnosed deflation. In reality, the policy based on this did not serve to ensure price stability, but other goals. The financing costs of the euro states should be kept low and the risk premiums on government bonds largely leveled out, so the market should be switched off. This was embellished by the argument to avoid “fragmenting” the bond markets in the euro area.
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The ECB threatens to continue its asymmetric approach of aggressively cutting rates as the economy slows but keeping a steady hand as inflation rises. She is now challenged, both communicatively and operationally. It must make it clear that it gives absolute priority to its goal of ensuring price stability, as required by the European treaties – without ifs and buts! But communication alone is not enough. It is important that the Governing Council of the ECB finally takes action and proves credibly with operational decisions that it does not tolerate high inflation rates.
Inflation: Governing Council of the ECB must raise interest rates
The Council must free itself from the shackles it has imposed on itself in the past. In concrete terms: the key interest rates must be brought out of the negative and zero range immediately and then increased significantly. And the bond purchases are to be stopped – as early as this summer. Even if such political decisions only have an effect in the medium term, such a signal is a critical momentum to demonstrate the Governing Council’s determination to turn around and decisively counteract the inflation dynamic.
That could have happened already, if necessary at a meeting of the Governing Council outside the usual meeting rhythm. This would no doubt have helped limit the loss of confidence in the ECB and the stability of the euro. Now the signals and the decisions must be all the clearer in the forthcoming ECB Council meeting.
More on this: ECB minutes: Monetary authorities fear stagflation.