Monetary policy: Commerzbank chief economist calls for higher ECB interest rates

At first glance, the European Central Bank (ECB) is now taking decisive action against record high inflation. After all, it surprisingly recently raised its key interest rate by half a percentage point. But the first members of the Governing Council are already squinting at sentiment indicators such as the Ifo business climate, which has collapsed because of Putin’s war of aggression and possible gas rationing. An impending recession, so they calculated, would solve the problem of high inflation on its own, and significant increases in interest rates would no longer be necessary. But this strategy is dangerous.

The ECB has always reacted sensitively to a deterioration in growth prospects. A slight weakening of the economy in autumn 2019 was enough for the ECB President at the time, Mario Draghi, to get the ECB to buy bonds again.

This reaction pattern has a lot to do with the so-called Phillips curve, which is important in ECB thinking. According to them, an economic downturn increases unemployment, weakens the bargaining power of workers and causes inflation to fall via slowing wage increases.

Inflation disappears on its own when the economy slows down. It is not for nothing that a simulation by the ECB shows that inflation would fall back to the ECB target of two percent in the medium term if gas supplies were stopped.

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A look at history helps: The recession of the 1970s

But the ECB should study the 1970s carefully. Back then, recessions didn’t solve the problem of high inflation. Because many central banks pursued a loose monetary policy out of misunderstood consideration of the weak economy, they also fueled inflation without ultimately helping the economy.

Inflation was so high at the time, despite a weak economy, because the economic problems were not, as is usually the case, due to a collapse in demand, which is in fact slowing down inflation; when there is less demand chasing the goods supplied, prices fall.

But the oil price shock of 1973 did not primarily cause demand to collapse, even if expensive oil reduced consumers’ purchasing power. Instead, it was primarily the supply of goods that was affected.

The companies suffered from the exploding oil price. They had to reduce the use of oil, which had become expensive, and were therefore able to produce fewer goods, with gross domestic product collapsing.

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Because aggregate demand met a lower supply of goods, inflation picked up. Unlike before, recession and high inflation rates went hand in hand.

Wrong diagnosis, wrong therapy

The fact that inflation remained high for a long time after the oil price shock was due to the prevailing economic policy at the time, which did not see the supply shock. The problem was misdiagnosed and the wrong therapy was used: governments wanted to stimulate the economy by increasing aggregate demand.

In the USA in particular, and to a lesser extent also in West Germany, the central banks, which are often dominated by politicians, pursued a loose monetary policy. The governments launched economic stimulus programs, and in Germany the trade unions fueled demand with high wage agreements. More demand chased the supply of goods, which had shrunk due to oil prices.

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The expansive demand policy also fueled inflation. People ramped up their inflation expectations even as the interim recession sent unemployment skyrocketing. Increased inflation expectations led to higher wage deals, further increasing costs for businesses and fueling inflation.

All of this may sound like mere economic history. But since the outbreak of Corona, the similarities with the 1970s have caught the eye – with several consequences for the ECB’s monetary policy.

First, we are dealing with supply shocks again. Initially, companies were able to produce less because they lacked supplies due to the lockdowns, and this is likely to remain so for longer due to China’s zero corona policy.

Fighting inflation is less difficult today

In addition, energy has become massively more expensive, so that companies can offer fewer goods at the given prices. In addition, the federal government could soon have to ration gas for industry.

Secondly, since the outbreak of Corona, governments have been trying not only to help the sections of the population that were particularly affected, but also to increase demand across the board, as in the 1970s. This was particularly pronounced during the corona crisis, when the US government, for example, allowed its citizens’ incomes to increase by double digits at times due to a very loose fiscal policy. Governments in the euro area are also spending a lot of money, for example when you think of the €750 billion so-called Corona reconstruction fund.

The ECB headquarters in Frankfurt

Learn from experience and end the loose monetary policy: Commerzbank chief economist Kramer proposes an unusual course to the ECB.

(Photo: dpa)

Third, like central banks in the 1970s, the ECB supports governments with easy monetary policy. Since the outbreak of Corona, the ECB has financed almost the entire budget deficits of the member states with its bond purchases.

It is likely to continue buying government bonds as part of a recently approved new program when heavily indebted countries like Italy are said to have to pay excessive interest rates. The ECB will not be able to prevent such purchases from increasing the money supply and ultimately inflation.

But there are also differences compared to the 1970s. At the time of the 1973 oil price shock, the USA already had eight years of excessive inflation. In contrast, this time inflation has only been too high for a good year. In this respect, the inflation expectations of the citizens have not risen so sharply; fighting inflation is less difficult than in the 1970s.

No more loose monetary policy: what the ECB should do today

Nevertheless, the ECB must act decisively. It must not continue to push aggregate demand through loose monetary policy.

Instead, it should ignore the supply-induced recession risks, which it can do nothing about as a central bank anyway, and quickly raise its key interest rate to at least the cyclically neutral level. But that is not just between one and one and a half percent, as many ECB council members think.

Rather, the medium-term prospects for price-adjusted economic growth and the target inflation rate of two percent suggest a neutral interest rate of between two and a half and three percent. However, the ECB will probably have to go beyond that as inflation is well above its target. A base rate of four percent would probably be appropriate.

An interest rate of this magnitude seems very high after years of negative ECB interest rates. But if the ECB called off the rate-hike process for fear of mounting recessionary risks, it could end up like the US Federal Reserve, which needed a 20 percent interest rate in the early 1980s to quash inflation with a painful twin recession.

The author: Jörg Krämer is chief economist at Commerzbank.

More: Inflation in the euro zone climbs to a record 8.9 percent

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