This Thursday, according to market expectations, the European Central Bank will raise its interest rates significantly by 0.75 percentage points in order to get inflation under control again. But that’s not enough to restore their credibility.
The record-high inflation, which has long been underestimated by the monetary watchdogs, must have consequences for further strategic action. Because a “keep it up” would imply that in the end everything wasn’t so bad. But how bad it is is shown by the economic and social consequences of the high prices.
Some possible problems with the ECB’s and Fed’s monetary policy have already been mentioned in the public debate. The central banks have pursued the forward guidance approach for far too long: they wanted to use comprehensive communication to control the expectations of the players. However, this strategy has failed miserably in recent months. It probably prevented them from responding to new developments in a timely manner.
Another point are the weaknesses of the current models that economists use as a basis. Central banks use time series data, i.e. they rely primarily on past experience. However, the insights that can be gained from this data are not very valid when the much-cited “turning point” hits the economy, i.e. when the general conditions change fundamentally.
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In addition, the models usually classify strong fluctuations as exceptions and thus predict a decline to average values. Structural breaks that the data depict are insufficiently processed in the models.
Monetary policy: problems on the supply side
A particular problem are the ongoing supply bottlenecks as a central price driver, in addition to the energy crisis after Russia’s attack on Ukraine. This is where another weakness of the models becomes apparent: they often inadequately reflect drastic changes on the supply side. In many models, for example, sharply rising raw material prices are regarded as an external shock whose influence is gradually decreasing.
That doesn’t do justice to reality. Rather, the entire economic environment changes with higher raw material prices.
It is therefore important to differentiate when judging monetary policy: A central bank can stimulate demand – as it impressively demonstrated in the corona pandemic – but its policy can change little on the supply side. Nevertheless, the model world has to be adapted to the new experiences. The monetary policy strategy before Covid was also controversial, but the result may have been correct. However, new approaches are now required.
The ECB has already admitted that the models need to be revised. The central banks have also largely abandoned their forward guidance – and rightly so. They should now make it clear that in future situations of upheaval they will rely less on models that cannot reflect the new framework conditions anyway, and react more quickly to acute data.
>> Read here: Day of the decision – ECB targets record rate hike
Because they have to put up with the accusation of sticking to terms like “temporary” or “statistical base effect” for too long. It would have made more sense to deal more openly with the limited informative value of the models in this environment. The communicative turnaround came too late, so the inflation warnings are now pointing the finger at the central banks.
Just as bad as the immediate consequences of monetary policy mistakes are the longer-term repercussions. A key asset of modern monetary policy is at risk: its credibility. It is time for the ECB and other central banks to build up capital again on this point.
More: Four reasons why central banks have underestimated inflation.