Combat inflation without strangling the economy. The ECB is pursuing this goal with a strategy of not raising interest rates too much, but keeping them at this level for a longer period of time (“lower high for longer”). However, it risks inflation becoming stuck at a higher level. This would mean that the central bankers would have no scope for significant interest rate cuts for years to come, and the economy would have to keep the handbrake on.
The “two objectives” of the ECB
The ECB’s mandate is clear in and of itself: ensuring price stability in the euro area, which the ECB translates into an inflation target of 2% in its strategy. However, the ECB currently seems to be placing particular emphasis on achieving this goal without slowing down the economy too much. At least that is what the statements of a number of ECB Council members who like to talk about a “soft landing” scenario indicate. This is probably the main reason for the “lower high for longer” approach currently being pursued by the ECB, according to which interest rates are not raised any further, but are instead kept at this level for a longer period of time.
Unlike the ECB, the Federal Reserve has a dual mandate, according to which the US central bank is supposed to ensure price stability and full employment. But the Fed has apparently learned lessons from the past and now wants to avoid the so-called Volcker shock. In the 1970s, the Fed’s interest rate increases were not enough to permanently reduce inflation. On the contrary, when inflation flared up again, then-Fed Chairman Volcker had to raise interest rates even more drastically, which pushed the economy deep into recession. To avoid this, the Fed is now pursuing the approach of taking more bold action against inflation right from the start – largely regardless of the consequences for the economy and employment – in order to be able to lower interest rates back to a tolerable level later. In fact, it is also surprising for the Fed how well the economy has coped with the interest rate increases so far.
Both strategies have the same mechanics…
From a purely mechanical point of view, the two approaches initially work the same. Monetary policy is aimed at demand: a central bank can only combat inflation by dampening overall economic demand so that prices ultimately rise less quickly. Against this background, the two approaches seem comparable:
The Federal Reserve is acting more aggressively by raising interest rates more quickly. Fed officials would obviously prefer a soft landing, but are prepared to plunge the economy into recession if necessary to reduce inflation. The ECB is trying a softer approach and raising interest rates less sharply, but keeping them at this level for a longer period of time. The economy is slowed down less. The economy is driving with the handbrake on for a long time.
The signal makes the difference
The crucial difference between the two approaches is the signals that the two central banks send with their actions. Unlike physics, economic processes are not just about mechanics; expectations also play a crucial role. Decisive action by the central bank leads to companies, households and institutions (such as unions) adjusting their expectations accordingly. In the USA, monetary policy – accompanied by pithy statements from Fed Chairman Powell, who left no room for speculation from the start and were followed by further interest rate increases – appears to be having an effect on inflation expectations. According to the Survey of Professional Forecasters (SPF), the experts surveyed have noticeably adjusted their expectations for inflation downwards in the almost two years since the interest rate turnaround began. These are now back to around 2% (Fig. 1). The effect of monetary policy on inflation expectations in the market is less clear. However, these at least interrupted their slight upward trend during the interest rate hikes and were stable for several months until they recently increased slightly again (which was largely due to the long-term inflation swaps, whose yields increased as energy prices rose again since the summer).
In the euro area, the ECB’s interest rate increases have had little impact on inflation expectations on the markets. Long-term inflation expectations continued their upward trend without any noticeable slowdown during the interest rate hikes (Figure 2). However, the tightening of monetary policy seems to have at least ensured that experts’ expectations regarding inflation have not risen further in two years. However, at just under 2½%, they remain stubbornly above the ECB’s 2% target.
Of course, inflation expectations for the USA and the euro area had already developed quite differently before the interest rate turnaround. Inflation expectations were noticeably higher in the USA and only increased moderately during the price shock from spring 2021, whereas inflation expectations in the euro area started from a lower level and increased much more strongly in the wake of the price shock. In addition, the ECB initiated the interest rate turnaround later. Nevertheless, the effectiveness of the central banks’ monetary policy measures to date and the commitment of the central bankers at least seem to be of professional forecasters (SPF) to be perceived differently. Statements for European monetary policy, such as those made by ECB Council member Wunsch at the end of May that the ECB cannot design its monetary policy completely independently of its effect on public finances, are unlikely to have helped much. With view on MarketExpectations could even give the impression that the markets themselves do not trust the Fed to be successful in the long term in the fight against inflation. In any case, the risk of completely ignoring such signs is too high.
Canada as a cautionary tale?
A warning example could be Canada. Inflation in Canada – measured by the Bank of Canada’s preferred core inflation rate – followed a similar trajectory to that in the United States. It began to rise at the beginning of 2021 and reached a high point of just over 5% in spring 2022 (Fig. 3). The Bank of Canada responded by raising interest rates by a total of 475 basis points – similar to the 450 basis points by which the ECB raised interest rates. At 5%, Canada’s key interest rate is between the key interest rates in the euro area and the USA. However, inflation in Canada is extremely stubborn. The core inflation rate has been leveling off at just under 4% for several months, and the short-term inflation dynamics – measured as a 3-month average compared to the average of the previous three months, and extrapolated to the year – give little hope that it will fall noticeably any time soon. Rather, it has fluctuated between 3½% and 4% since autumn 2022. In view of the usual delay in effects, monetary policy in Canada is unlikely to have yet had its full effect. Nevertheless, given that underlying inflation has been extremely stable for a year, there is a risk that inflation could become permanent.
Better an end with horror…
Against the background of such risks and uncertainties and the fact that an optimal and tailor-made monetary policy is difficult to achieve in reality simply because of the delay in its effects, the International Monetary Fund (IMF) speaks out in one Study for a monetary policy that overshoots the target. The high interest rates would intensify the economic downturn (see “tight monetary policy” in Fig. 4). Because inflation is falling rapidly, the central bank can then significantly reduce interest rates again, which gives the economy room for a strong recovery. In the long term, the central bank can raise interest rates to the neutral level so that the economy can return to the long-term growth path and inflation can return to the target value. In the long term, the IMF believes this strategy is better than a lax monetary policy that underestimates the persistence of inflation and fails to sustainably push inflation down to 2% (see “baseline scenario” in Chart 4).
…as a never-ending terror
This is precisely the risk we see for the ECB: The interest rate increases so far have obviously not been enough to sufficiently reduce inflation expectations, and there are increasing signs that the ECB will not raise its key interest rates further in view of declining inflation and the weak economy. This means that it is unlikely to be able to bring inflation down to 2% permanently. This is all the more true as structural factors such as the reversal of globalization, the aging of (global) society and the change in the economy towards an environmentally friendly mode of production will generate significant inflationary pressure in the coming years. The (underlying) inflation will therefore remain high.