The European Central Bank, still waiting for Godot? – POLITICS


Otmar Issing is president of the Center for Financial Studies. He is the former chief economist and board member of the European Central Bank.

During the Great Moderation, a long period of low and stable inflation, continuous growth and moderate unemployment from the mid-1980s until the financial crisis of 2007, the risk of higher inflation was completely ignored, even in circles central banks.

However, since inflation began to rise well above the 2% target in 2021, a number of central banks have placed themselves in the “transitional camp”, expecting inflation to back to earlier lows via self-correction, so to speak, seeing no need to act to counter the risk of higher inflation. Until the end of last year, the European Central Bank (ECB) even went so far as to announce that sooner rather than later it would once again be faced with a situation of too low inflation, predicting that the rates fall below its 2% target. – probably one of the biggest forecasting mistakes made since the 1970s.

But the ECB has significantly underestimated inflation since mid-2021, and even before the Russian attack on Ukraine had to revise its inflation assessment upwards several times. And the problem of this underestimation has a deeper source, largely ignoring that traditional models are incapable of accounting for substantial structural changes.

Any inflation forecast is based on assumptions about various exogenous variables, with oil and other energy prices playing an important role. This is why the ECB uses the term projections, indicating that the services base their work on assumptions.

But the pandemic, as a combination of supply and demand shocks, is causing a persistent negative shock to potential output and is a major source of structural problems that had to be addressed by targeted and temporary fiscal policy measures. The Federal Reserve System in particular, but also to some extent the ECB, underestimated the inflationary impact of expansionary fiscal policies.

Today, a major structural change is taking place at the global level.

When economists Charles Goodhart and Manoj Pradhan analyzed the main factors that are changing the international environment, from a disinflationary impact to a world where inflationary influences will dominate, demographics was a major factor, but so was the rise of protectionism. . And the war in Ukraine will reinforce the intention to reduce dependence on foreign energy sources as well as other essentials in all countries.

But what are the consequences of these developments for the monetary policy of the ECB?

It is difficult to understand why the ECB has remained so long in the crisis mode it adopted after the financial crisis of 2007-2008. Quantitative easing, with zero or even negative interest rates and the continuation of net bond purchases, was no longer appropriate in a period when the economy was improving and unemployment was at an all-time low. since the start of the euro.

Now, faced with inflation rates not seen since the existence of the euro, the ECB has just begun to consider a very late exit and, as the announcements suggested, still timid of the crisis mode of monetary policy .

It is true that monetary policy cannot control energy prices and must override temporary price shocks — its role is to prevent inflation expectations from losing their anchor and wages/profits from an upward trend. The pandemic, military spending induced by war and other geopolitical crises, spending due to aging populations and climate policy will all contribute to increased public spending. This implies a high risk that debts, having already reached historically high levels, will increase further, with consequences for the sustainability and credibility of public finances in several countries. Efforts to weaken fiscal rules could further undermine fiscal discipline and contribute to inflationary pressures.

As a negative supply shock, the war indicates the risk that the Eurozone is heading towards stagflation, and starting to emerge from crisis mode under such circumstances is a big challenge for central bankers. But, as the experience of stagflation in the 1970s shows, letting inflation rise unchecked is not an appropriate option for a central bank whose mandate is price stability.

There is no more time to wait for drastic actions – Godot will never come.




Politico

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