“Inflation requires aggressive action by the ECB”

Interest rates in the euro area have continued to fall for many years. Now they have to be raised abruptly in the face of high inflation. Doesn’t that get highly indebted countries like Italy into trouble?
In any case, inflation is too high and requires a more aggressive approach from the ECB. This can also lead to the yield premiums of certain countries compared to German Bunds increasing. But if you look at real interest rates, the current level is still very low.

The nominal yield on ten-year Italian government bonds was around 1.2 percent at the beginning of the year – recently it was over four percent at times.
Yes, but inflation is at eight percent. If the interest rates in Germany are then one or two percent and in other countries one or two percent higher, then in real terms, i.e. after deducting inflation, I still have an interest rate of minus four percent. From the point of view of debt sustainability, inflation means that the debt is inflated away. Measured against this, debt sustainability is easier today than it was two years ago.

Do government revenues really rise that much due to inflation?
Normally yes. Sales tax goes up, income tax, corporate profits and, as a rule, wages too. Of course, you have to be careful that the additional funds are not consumed by exceptions or special programs such as the tank discount. You also have to take into account that part of this flows abroad as a result of higher energy expenditure.

Then the new instrument that the ECB is planning is superfluousin order to prevent, from your point of view, exaggerated widening of yield premiums, the so-called spreads of individual euro countries?
In view of the communication so far, there is no way around presenting something, although the OMT bond purchase program is already an instrument. It is now important that the instrument is properly designed. There are two types of equilibria in spread development. In the best case, you don’t need such an instrument. But if spreads jump sharply higher, there is a risk of entering a poor equilibrium where debt sustainability would no longer exist.

In your opinion, how could the instrument be designed in a meaningful way?
The ECB should not target a spread cap. Otherwise it would be an invitation for speculative attacks. The program should also be limited in time and force governments to agree on a clear and binding fiscal policy framework in Europe within this year.

According to Executive Board member Isabel Schnabel, the ECB only wants to react if yield spreads shoot up for speculative and not for fundamental reasons. Can it be so clearly distinguished?
A signal that you are jumping from good to bad equilibrium is often when spreads jump even though fundamentals haven’t changed much.

There are already political attacks on the ECB. When the June meeting did not decide to take any measures against the widening of individual country spreads, the Italian politician Matteo Salvini spoke of an attack on Italy. Doesn’t the ECB raise too many expectations with such an instrument?
That danger is there, which is why how you communicate is so important. If spreads are slowly increasing, then that’s how it’s supposed to be. Interventions are only justified if they pick up very quickly and there are no fundamental reasons for it. If a government does something weird and spreads go up as a result, the central bank has to let it go.

This makes her unpopular.
That is their job too. There are independent central banks for this, otherwise the tasks could have been transferred to the Ministry of Finance. In the past twenty years, central banks have been able to play Santa Claus and hand out gifts. But now they also have to take on the role of Knecht Ruprecht and pull out the rod.

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You said that real interest rates, i.e. nominal interest rates minus inflation, are still very low. But won’t interest rates also rise significantly in real terms?
Yes, so I think it’s important that the ECB reacts relatively aggressively now so that it has to do less later. This would also be cheaper for Italy in the long term. Italian government securities have relatively long maturities, averaging seven years. So they are fully financed with very, very low interest rates in real terms.

In your opinion, what would be “relatively aggressive”?
I would take a bigger step and go up 50 or 75 basis points to show that you are serious about this, in order to keep the inflation anchor. After that, it should rise to one percent relatively quickly. The next steps would then depend on the more recent developments.

Wouldn’t the ECB trigger a recession with aggressive action?
The question is, do I now want to rule out a minor recession with all my might, but risk having a major one?

Either way, will there be a recession?
We may still manage a soft landing. But if inflation becomes entrenched, the only way we can bring it down is through a bigger recession.

Like the US Federal Reserve, the ECB underestimated inflation for a long time. Does this damage their credibility in fighting inflation?
I think the Russian war makes it easier for the ECB to hide behind the incident. As a result, she loses less reputation. But inflation was already rising before the war started, and she underestimated it.

Why was that?
I believe, above all, in the prevailing mentality. Many feared deflation, i.e. prices falling. It has been seen in Japan that the aging of society can put downward pressure on prices and that a situation of very low inflation and low growth can arise. Therefore, the higher inflation was initially seen as a welcome opportunity to get out of this deflationary trap.

The Fed and ECB have also adjusted their strategies with a greater focus on avoiding deflation. What role did that play?
In the US in particular, the entire strategic reform was aimed at deflation. It has been argued that if inflation has been too low for a long time, it will be caught up later. There was also the approach that monetary policy was no longer pursued with foresight. This new philosophy then spilled over to Europe.

You made more and more, and inflation came and didn’t come. And then she came all of a sudden.
Yes. There’s the ketchup theory: first nothing comes out of the ketchup bottle, and when the red sauce runs, it’s too late. This theory was no longer taken seriously. It used to be different for people who had experience with the anti-inflation campaign of the 1970s and early 1980s.

How long will inflation stay high?
That depends on how energy prices develop. And it depends on wage developments. If wages rise only moderately, demand may be stifled because people have less in real terms, and then inflation may come back.

The German unions are not known for exorbitant wage demands.
I don’t see that either. But it shouldn’t be the case that wages are kept low in Germany and rise more sharply in the rest of the euro zone. That would lead to new tensions in the currency union. In Belgium, for example, wages are automatically indexed.

The federal government is committed to one-off payments.
But at the current rate of inflation, workers lose 8 percent forever. There is the question of whether they can be fobbed off with one-off payments. The United States has also recently seen that, for the first time in a long time, the gap between the wages of well- and poorly-trained workers has narrowed because wages at the lower end have risen much more sharply. This tendency could also exist in Europe.

Why is that?
In the pandemic, many jobs were abolished that are now needed again. As a result, there are bottlenecks, especially among less qualified workers.

The high inflation is now causing the central banks to have to raise interest rates very abruptly. Isn’t that an ideal breeding ground for crises?
There may already be tensions in the financial markets. But that doesn’t have to spill over into the real economy. When the Fed raised interest rates very sharply by around three percentage points at the beginning of the 1990s, there were considerable distortions on the bond markets, but no recession.

Where do you currently see the greatest vulnerabilities?
These are certainly the energy prices for Germany at the moment. But I am also confident that the German economy will adapt. Otherwise, my biggest concern right now is cyber attacks. I’m surprised how few cyber attacks we’ve seen lately, despite the war.

Mr. Brunnermeier, thank you very much for the interview.

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