Constantly predicting that the rise in global inflation will only be temporary is a fatal mistake. European central bankers should no longer proclaim like a prayer wheel that price pressure will soon ease again. Instead, it would be better to tell the public and financial markets: “The resurgence of inflation – in some leading industrial countries it has reached its highest level in 30 or even 40 years – is serious business.”
In accordance with their mandate, the central banks are called upon to vigorously tackle the inflation problem. A clear signal must therefore emanate from the annual meeting of the Council of the European Central Bank (ECB) on December 16: The time for appeasement is over!
After the pandemic-induced recession, the global economy is in an unstable state. If central banks react sensibly and moderately to inflation risks, they will rather prolong the economic recovery than jeopardize it.
If they do not act now, however, the upswing could be severely slowed. Because inflation will lower real incomes, which is likely to result in high wage demands from unions and employees. A wage-price spiral may then threaten.
The causes of current inflation are many and complex. Some problems emanating from the supply side – interrupted international supply chains, weakening of globalization, restrictive policies of the oil-producing countries – will indeed weaken, but other problems will remain: For example, the private savings created in the wake of Corona through forced renouncement of consumption will have to dissolve again at some point.
And an end to the boom on the property market, which is leading to rising rents, is not in sight, despite political countermeasures. The inflation statistics do not adequately reflect the rent increase – but these two factors alone have a significant impact on the general price level. So it’s illusory to pretend they’re going to just go away.
The policy of low interest rates increases financial vulnerabilities
A major risk is that if the central banks are too hesitant to turn away from their loose monetary policy, they will later force them to turn around much more abruptly and reduce liquidity accordingly. That would clearly cause greater damage to the global economy than if the central banks put the brakes on in good time.
A recently published “Working Paper” by the Bank for International Settlements shows: The long-standing low interest rate policy has increased financial vulnerabilities and prevented productive investments.
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The two most important central banks in the world are discussing a tighter course. One thing is already clear: the gap between the USA and Europe will widen in 2022. Read the Handelsblatt analysis here.
The US Federal Reserve Chairman Jerome Powell has now recognized the signs of the times. At a congressional hearing earlier this month, he announced that he would remove the word “temporarily” from his vocabulary in view of inflation developments. “The risk of higher inflation has increased,” he said. In fact, the inflation rate in the US has recently risen to 6.8 percent – the highest level in four decades.
Powell signaled that the Fed would probably end its “quantitative easing” policy a few months before the initially planned June 2022 date. That is a strong signal – and an urgent message, especially for Europeans.
The high corona incidence numbers and the new Omikron variant do not, of course, make things any easier for the ECB. Still, it should now confirm that its Pandemic Emergency Purchase Program (PEPP) will finally expire on March 31, 2022. It could possibly consider a modest, temporary increase in its government bond purchases under the Asset Purchase Program (APP) that has been in place for several years. The relative tightening of monetary policy in the financial markets would not cause any great nervousness.
Faster rate hikes
However, a reduction in government bond purchases alone does not lead to a substantial rise in interest rates. Real interest rates remain extremely negative due to high inflation rates. In return for the continuation of the “normal” APP bond purchases, the ECB should therefore offer the prospect of direct interest rate hikes.
The central bank should now make it clear that the key ECB interest rate for the deposit facility – currently minus 0.5 percent – will be increased before and not shortly after the end (as it has so far put it) of the government bond purchases.
Such an announcement would change the intended order in which their monetary policy tools are deployed. The primary task of the ECB is price stability. A change in the order of your future credit tightening steps is urgently needed because of the increased inflation rates.
So far, the logic of the ECB has been based on the assumption that the inflation rate will return to the two percent target from next year. However, this seems doubtful given the fact that the inflation indicator preferred by the US Federal Reserve is now showing an inflation rate of five percent in the US for the next twelve months. In the European Union, too, inflation is likely to prove more persistent than assumed some time ago.
Because at least the development of a certain wage-price spiral is quite possible in 2022. The entrepreneurs would strive to counter high wage demands with significant price increases – with a tendency to maximize profits. In addition, the aging of Western societies alone will lead to a worsening labor shortage, which should tend to strengthen the position of employees and trade unions in collective bargaining disputes.
Waiting doesn’t make life any easier
In addition, the national economies must prepare for a radical transformation in the fight against the global climate crisis. However, decarbonization is not available for free, it is actually becoming expensive. So there are a number of structural factors that point towards higher rather than lower inflation rates.
Central banks should normally tighten their monetary policy when inflation threatens and signs of overheating are evident in at least some economic segments. Instead, we have seen the opposite so far: a significant de facto easing. The rise in inflation from one to 4.4 percent has so far not led to a significant correction in negative ECB interest rates or bond purchases.
To justify this with the assurance that the price pressure is only “temporary” is no longer sufficient. It is time for the ECB to reverse monetary policy. A policy of waiting does not make life easier – neither for the central banks nor for the economy.
The authors: Jacques de Larosière was Director of the French Treasury, Executive Director of the International Monetary Fund, Governor of the Banque de France and President of the European Bank for Reconstruction and Development. David Marsh is co-founder and chairman of the independent think tank Official Monetary and Financial Institutions Forum (OMFIF), which deals with central banks, economic policy and public investment.
More: The ECB risks its independence.