However, what the ECB and many other central banks do not reveal is that their instruments are not sufficient or not effective enough to be able to achieve the mandate of price stability in the foreseeable future. The new strategy is dangerous and could prove detrimental to the credibility and hence effectiveness of monetary policy because it makes a promise that most central banks cannot deliver.
We are currently seeing an overbidding competition in the communication of the central banks. US Federal Reserve Chairman Jerome Powell has signaled his willingness to push the US economy into recession by raising interest rates in order to get inflation under control.
A communication competition has also emerged within the ECB Central Bank Council, in which calls for a tough monetary policy course with supposedly significant effects on inflation are being made public more and more frequently
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Monetary policy is the art of expectation management
Monetary policy is primarily the art of managing expectations, in which clever communication can at least partially replace monetary policy action.
The task of central bank communication is to anchor expectations and steer economic actors in a desired direction in order to reduce uncertainty and volatility in markets. To this end, they not only communicate the possible course of monetary policy to the economic policy actors, but also other relevant information.
Such communication can be highly effective. For example, long-term interest rates on government bonds in the euro zone have risen by an average of a good two percentage points in recent months, even though the base rate was only raised by 0.5 percentage points.
Above all, however, central banks want to anchor inflation expectations well. In other words, with their warnings, central banks want to convince the economic actors – trade unions, companies, consumers and governments – to refrain from raising prices and wage demands as far as possible in order to prevent a wage-price spiral, i.e. a vicious circle of rising prices impede.
> >Read here: Inflation in the euro area rises to a record level – Bundesbank boss calls for “major interest rate hike”
This communication strategy could fail and even become counterproductive as it promises more than it can deliver. After all, it can only be successful if central banks can back up their words with corresponding deeds.
This worked impressively well during the European financial crisis: the ECB introduced the OMT emergency program in the summer of 2012, which never had to be used precisely because the markets were convinced of the ECB’s full ability to act.
But it is precisely this capacity to act that many central banks do not have at the moment. The ECB can neither significantly reduce inflation nor increase key interest rates quickly and sharply in the next twelve months.
On the one hand, because the main cause of the high inflation is beyond the control of the ECB: the price increase is primarily caused by imported goods, above all energy. On the other hand, every interest rate increase takes a good year and a half before it can have its full effect on the economy.
Even if the ECB wanted to continue raising interest rates massively, it could hardly do so. Not because governments with high debts would get into trouble. But because a very sharp rise in interest rates would endanger financial stability and risk a deep economic crisis.
With its policy, the ECB takes the pressure off governments to fight inflation as well
If its communication strategy failed, the ECB would lose credibility and its monetary policy would be less effective as a result. How will economic actors perceive the ECB two or three years from now if inflation is persistently at 3 or 4 percent and the ECB cannot bring inflation back to its promised level of 2 percent?
It will then be much more difficult for them than it is now to anchor inflation expectations well and prevent a price-wage spiral. The ECB thus runs the risk of missing its mandate of price stability for a much longer period of time than is already unavoidable.
The ECB’s new communication strategy is also risky and counterproductive for a second reason, because the ECB’s promises suggest that it alone can ensure price stability.
Not only is this wrong, but it takes the pressure off governments to meet their own responsibilities. Fiscal policy is likely to have at least as much impact on inflation and inflation expectations as monetary policy over the next year and a half, which should involve closer and at least implicit coordination between monetary policy and fiscal policy.
Large and well-targeted relief packages will be essential throughout the euro zone in order to reduce the likelihood of a price-wage spiral. Instead of putting the trade unions under pressure in concerted action, the federal government itself should also meet its responsibilities and, above all, get inflation under control in the case of electricity and gas prices.
The ECB should honestly admit that inflation will remain too high for years to come
The ECB faces a difficult dilemma: With its warnings and promises, it wants to prevent inflation expectations from rising too much. If it fails, those promises could boomerang, damaging its credibility and hence the effectiveness of monetary policy for many years to come.
Therefore, a strategy of honesty would be the better alternative: the ECB should accompany significant interest rate increases – which are now right and necessary – with communication that explains openly and honestly why we in the euro zone are asking for too high a rate for the next three years inflation will have – and that the responsibility for this does not lie solely with the ECB, but also with the governments.
These should prevent a recession with clever, well-targeted aid packages, mitigate the costs of inflation and relieve the weakest shoulders. As a result, the ECB could at least free itself a little from fiscal dominance and no longer allow itself to be dragged along by politicians and the media, especially in Germany.
Such a strategy of honesty would protect the credibility of the ECB and enable it to more quickly fulfill its price stability mandate in the future.
The author:
Marcel Fratzscher is President of the German Institute for Economic Research (DIW Berlin) and Professor of Macroeconomics at Berlin’s Humboldt University.
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