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The European Central Bank — still waiting for Godot?

Otmar Issing is president of the Center for Financial Studies. He is the former chief economist and member of the board 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 to the financial crisis of 2007, the risk of higher inflation was entirely off the radar, even in central bank circles.

Ever since inflation started to rise well above the 2 percent target in 2021, however, quite a number of central banks have placed themselves in the “transitory camp,” expecting inflation to return to prior low levels via self-correction, so to speak, seeing no need for action to counter the risk of higher inflation. Until the end of last year, the European Central Bank (ECB) even went so far as to communicate that, sooner rather than later, it would once again face a situation of too low inflation, projecting rates would fall below its target of 2 percent — probably one of the biggest forecast errors made since the 1970s.

But the ECB has been severely underestimating inflation since mid-2021, and even before the Russian attack on Ukraine, had to repeatedly revise its inflation assessment upward. And the problem with this underestimation has a deeper source, largely ignoring that the traditional models are unable to take substantial structural changes into account.

Any forecast of inflation 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 — signaling that the staff bases its work on assumptions.

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

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

When economists Charles Goodhart and Manoj Pradhan analyzed the main factors that bring change to the international environment, from a disinflationary impact to a world were inflationary influences will dominate, demographics were a major factor, but so was the rise of protectionism. And war in Ukraine will strengthen the intention to reduce dependency on foreign sources of energy as well as other essential products in all countries.

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

It is hard to understand why the ECB has remained in the crisis mode it adopted after the 2007–08 financial crisis for so long. Quantitative easing, with zero or even negative interest rates and the continued net purchases of bonds, was no longer appropriate in a period when the economy was improving and unemployment was at its lowest level since the start of the euro.

Now, facing inflation rates not seen since the euro’s existence, the ECB has just started to consider a very late and, as gleamed from announcements, still timid exit from the monetary policy crisis mode.

It is true that monetary policy cannot control energy prices and should look through temporary price shocks — its role is to prevent inflation expectations from losing their anchor and wages/profits starting an upward trend. The pandemic, war-induced military spending and other geopolitical crises, expenditures due to aging populations, and climate policy will all contribute to higher public spending. This implies a strong risk that debts, having already reached historically high levels, will increase even 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 pressure.

As a negative supply shock, the war indicates the risk that the euro area is heading toward  stagflation, and starting to get out of crisis mode under such circumstances is a big challenge for central bankers. But, as the experience of stagflation in the 1970s demonstrates, letting inflation rise uncontrolled is no appropriate option for a central bank with the mandate priority of price stability.

There is no more time to wait on forceful actions — Godot will never come.

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