Inflation in Germany and large parts of Europe is currently around ten percent – and thus at a level that most observers considered impossible just a year ago. Nevertheless, in retrospect one has to admit that inflationary tendencies were already evident before the outbreak of the Ukraine war. Exactly one year ago, the rate of price increases in Germany was an impressive 4.5 percent and has already exceeded the European Central Bank’s (ECB) target of two percent for six months in a row.
Nevertheless, for a long time those responsible for monetary policy never tired of explaining the surge in inflation back then with the aftermath of the pandemic and with the re-increase in the standard VAT rate. Today we know that this was a striking misjudgement.
As a result of the Russian invasion of Ukraine, world prices for oil and natural gas exploded. This triggered price surges, especially in the industrialized countries of Europe, which went beyond what had been experienced in the 1970s.
Furthermore, a US economy stimulated by huge economic stimulus programs led to demand-driven inflation, which the US Federal Reserve tackled with massive interest rate hikes, which led to a significant appreciation of the US dollar. As a result, the euro continued to lose value, which exacerbated imported inflation in the euro area and ultimately led to an unanchoring of inflation expectations.
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Since, as is well known, inflation prevails when people believe that inflation prevails, the ECB has no choice but to fight the far too high inflation with massive interest rate hikes. Yesterday it raised the key interest rate again by 0.75 percentage points.
Of course, the ECB Presidium knows that it is ultimately powerless against this surge in inflation. President Christine Lagarde and her team should be aware that even significant interest rate hikes will not affect world energy prices or end China’s senseless and price-boosting lockdown policy. Nevertheless, this ECB policy is the right way to bring inflation expectations back close to the two percent target.
Prof. Bert Rürup is President of the Handelsblatt Research Institute (HRI) and Chief Economist of the Handelsblatt. For many years he was a member and chairman of the German Council of Economic Experts and an adviser to several federal and foreign governments. You can find out more about the work of Professor Rürup and his team at research.handelsblatt.com.
To make matters worse, however, increases in key interest rates only have an inflation-dampening effect after a delay of four to eight quarters. Since it is also necessary to counteract second-round effects, for example with strong wage increases, the tightening of monetary policy is the right way to anchor inflation expectations again close to the two percent target.
However, the unavoidable side effects of a restrictive monetary policy become apparent much faster than the desired effects. Building and loan interest rates have already risen significantly and will continue to do so. This puts a strain on the market for residential real estate, slows down investments that are urgently needed for the economy as a whole, leads to sharp price losses for bonds and shares and makes financing public debt more expensive.
The right monetary policy in the matter increases the risk of a recession and its social consequences. However, this has to be accepted, since unchecked overheating would threaten a more massive slump and even higher social costs.
There is a lack of purchasing power and affordable energy
This is exactly where the responsibility of national governments, or more precisely: fiscal policy, comes into play. The governments of the countries of the currency union are not responsible for monetary stability. Nevertheless, they are held responsible and held accountable by the voters.
Now you can read in textbooks that fiscal policy and central bank policy should, if possible, aim in the same direction. But the upcoming recession is different. The significantly declining savings rate shows that consumers are not lacking in spending, but rather in purchasing power on the one hand and industrial pre-products and, above all, affordable energy on the other.
That is why the federal government – like other governments in the currency area – is trying to shield citizens and business from the consequences of inflation with its “double boom” as best it can. On closer inspection, however, such a “protective shield” is nothing more than a huge, credit-financed economic stimulus program of an unprecedented magnitude to support private consumption.
While the ECB is stepping on the brakes, the governments are stepping on the gas. What seems counterproductive at first glance may well be appropriate in the current situation. In the face of record inflation, the ECB cannot and must not sit idly by. Otherwise it would run the risk of jeopardizing its most valuable asset, its own reputation, and would itself pose a risk to the continued existence of monetary union.
However, there is a high probability that the tight monetary policy will help push at least parts of the euro zone into a deep recession. In the interests of its reputation and credibility, the ECB is thus exacerbating the negative macroeconomic consequences of the rise in energy prices. Taken by itself, this would mean that there is a risk of higher unemployment, increasing bankruptcy figures and personal bankruptcies. In short, welfare losses and poverty would increase – which would certainly not be in the interest of the ECB.
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A textbook alignment of monetary and fiscal policy cannot therefore be the order of the day. Rather, it is the by no means trivial task of governments to design programs that help those in need without noticeably increasing real aggregate demand and thus having an inflationary effect.
Microeconomists will now argue, rightly so, that every increase in income leads to higher demand and can therefore ultimately have an inflationary effect. On the other hand, in a rich country like Germany, it is a requirement of the welfare state to protect the poorer sections of the population from a loss of real income as much as possible. A high degree of financial sensitivity is therefore required.
The Economist recently suggested that central banks could raise their inflation targets from 2% to 4%. This “brave new world” with slightly higher government spending and slightly higher inflation would – so the argument goes – have advantages over the status quo. In the short term, this would reduce the likelihood of a recession, as the central banks would no longer have to slow down as sharply. In addition, in the longer term, central banks would have more leeway to lower interest rates without having to resort to unconventional measures.
The ECB has so far stuck to its two percent target for inflation.
(Photo: dpa)
Ultimately, this proposal amounts to an inflation tax. Moreover, a higher inflation target would hardly be politically feasible in Germany, since the fear of currency devaluation is particularly widespread in Germany, especially since the danger of self-fulfilling prophecies of both rising government debt and rising inflation expectations would be quite real.
Nevertheless, it seems high time to discuss such a regime change without prejudice and to weigh up the opportunities, risks and effects on citizens and companies. The biggest mistakes in economics are misconceptions that reflect the assumption that current regimes will last forever, that is, everything will remain as it is. But it never does.
There will always be black swans – and they always have the ability to come unexpectedly.
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