The Christmas tree at home beckoned as board members of the European Central Bank (ECB) concluded their last meeting of 2021 on December 16 last year. Their message, expressed by ECB chief Christine Lagarde: “It is very unlikely that we will raise interest rates in the year 2022.” The rising inflation in the eurozone, then just 5 percent, had been predicted by La-garde earlier that month a “bump” named. An interest rate hike to curb inflation (higher interest rates curb economic activity, and thus price increases) seemed unnecessary for the time being. Because, according to the ECB estimates, inflation would automatically fall to more than 3 percent this year and just 2 percent next year. The ECB is aiming for 2 percent inflation within about two years, so the picture looked favourable. Only the bond purchase, with which the ECB is pushing long-term interest rates, was reduced a bit. There was a lot of “uncertainty,” Lagarde said.
In retrospect, only the latter was true. Because everything else didn’t go as planned. This week, the ECB’s board will pave the way for a first rate hike next month, or just maybe this month. Because that ‘bump’ of inflation has turned out to be a huge mountain, the top of which may not even have been reached. In May inflation in the eurozone was 8.1 percent, a record. The ECB meeting will take place on Wednesday and Thursday in the Amsterdam Hermitage – meeting once a year in a beautiful location outside Frankfurt, where the ECB is located.
The first half of 2022 has turned the world upside down for the ECB, the institution responsible for keeping prices stable in the eurozone. Time and again inflation figures have been higher than the projections of the ECB and NCBs. The quality of those estimates has now been deeply doubted. Relations within the ECB board have become tense: the board members who have always been in favor of higher interest rates (called ‘hawks’) are feeling strengthened at the expense of the ‘pigeons’ who fear that higher interest rates will hit the economy.
Uncomfortable feeling
Meanwhile, an uneasy idea has started to gnaw among European central bankers: the ECB may be acting too late and running behind the times. Other central banks, such as the US Fed, the Bank of England and the Swedish Riksbank, also initially misjudged the severity and duration of inflation, but have already raised interest rates. Often several times. Those central banks have also scaled back the purchase of sovereign debt, which is pushing down capital market interest rates, faster than the ECB, which is still buying it until the end of this month.
More than other central banks, the ECB is struggling to adjust to the current inflation wave, which has brought an abrupt end to more than a decade of extremely low inflation since the 2008-2009 financial crisis. The corona pandemic and the war in Ukraine formed a double break with the old situation. ‘Corona’ caused hitches in supply chains and disrupted the labor market as entire sectors were out of work, while others peaked. The sudden shortages led to rising prices, also because governments gave massive emergency aid, so that consumers continued to spend a lot of money. ‘Ukraine’ is pushing up energy prices in particular, which is now having an effect on almost all other prices. No one knows how long the new era of inflation will last – but it’s clear that it won’t just end.
Also read: How should the ECB fight inflation in these wartime times of recession?
Shortly after the December meeting, the ECB was overtaken by the facts. In January, the Eurostat statistics office released a very unfavorable inflation figure for December. Central bankers are mainly looking at ‘core inflation’, which excludes the rather volatile energy and food prices. This core inflation better reflects underlying price pressures. Contrary to what the calculators at the ECB had expected, core inflation (2.6 percent in November) did not fall below 2 percent, but remained at the same level. This caused unrest in Frankfurt. In the February meeting, Lagarde’s tone changed. She no longer ruled out an interest rate hike in 2022: “Inflation may well turn out higher than we expected.”
A group of hawks, including Klaas Knot, the president of De Nederlandsche Bank, wanted to draw immediate consequences in the February meeting. The purchase of government and corporate bonds had to be accelerated, so that interest rates could also rise faster afterwards (the ECB has always said it would operate in this order). Those hawks didn’t get their way then – but they did in March, when a fourth-quarter rate hike first came into view.
In the months that followed, this pattern was repeated: record inflation followed record inflation, hawks’ impatience swelled, followed by a delayed adjustment of communications about the first rate hike. There are now few inveterate pigeons left within the 25-person board. Interest rates are now expected to rise in July from minus 0.5 percent to minus 0.25 percent, and again in September, from minus 0.25 to 0 percent. Knot recently suggested the possibility of a larger rate hike in July, immediately from minus 0.5 percent to 0. ING economist Carsten Brzeski takes into account in an analysis a surprise: the interest can already be increased this week in Amsterdam.
Cold feet
A series of rapid rate hikes is the classic means for central banks to quell raging inflation. At a higher interest rate, borrowing becomes more expensive, which slows down consumption and subsequently price increases. It also makes saving more attractive – causing consumption to fall further. Yet there is a lot of cold feet among European central bankers. The economic recovery after the pandemic is perceived as early, especially in southern Europe. A recession is looming, especially if Russia cuts gas supplies. An excessive hike in interest rates would only increase the recession risk. A specific problem for the ECB, which other central banks do not have, is the risk of rising borrowing costs for Italy and other debt-laden Member States, a phenomenon that determined the euro crisis of 2010-2012 around Greece, among others. Analysts assume that the ECB will promise to buy extra Italian debt in Amsterdam this week if necessary. This would put pressure on the Italian interest rate hike, while other interest rates could rise more. The ghost of Lagarde’s predecessor Mario Draghi, who promised to do “everything necessary” to save the euro, still haunts Frankfurt.
Lagarde – a woman from politics who strives for unifying leadership – is tasked with holding the ECB together a little bit during this whirlwind of price increases. She decided last month to organize the meetings differently: the chiefs of the national central banks get more speaking time, the ECB executives less. The Reuters news agency, which reported on this for the first time, explained this decision politically. ECB chief economist Philip Lane, whose department had repeatedly underestimated inflation, would lose influence. The Irish Lane is considered a pigeon and is also rather long in substance. The ECB also denies that Lane’s influence is being curbed by Lagarde.
It is clear, however, that things are rumbling inside the ECB tower in Frankfurt. In an article in the ECB journal, the Economic Bulletinsounded a mea culpa on the bank’s inflation estimates. The forecasts have “substantially underestimated” the “peaking” inflation, according to an article published in May by economists at the ECB and NCBs. The models behind the estimates failed to absorb the shocks of the pandemic and the war in Ukraine, the article says. This effectively removes an important basis for the ECB’s monetary policy. Because that policy, especially under Lagarde’s predecessor Draghi, has become increasingly based on those estimates. Inflation should reach 2 percent within two years. The policy is adjusted to the forecasts almost mechanically. Investors are told well in advance what the ECB will do (forward guidance, ‘guide forward’). Only, as it turns out, the ECB’s models are worth little. They are based on historical data and patterns, but do not include pandemics and wars. Because the policy has to be continuously adapted to the turbulent world, ‘guiding forward’ is also becoming less and less credible.
Mental shift
The new era of inflation, characterized by uncertainty and rapid change, demands things from the central banker other than model thinking: agility, an eye for multiple scenarios, independent judgment. Such a mental shift turns out to be difficult. People often make judgments based on their (recent) memories. The memory of central bankers is particularly marked by the very low inflation in recent years, which has mostly been well below the 2 percent target. That situation has almost started to feel ‘normal’. Klaas Knot warned last year that the memory of the sky-high inflation of the 1970s had all but faded. Of the current generation of central bankers, Knot said in an interview with NRC, “none have ever experienced true inflation.”
Big changes in monetary policy are forced during crises, German economist Hans-Helmut Kotz said recently during a webinar by think tank Bruegel. After the financial crisis, central banks adopted ‘unconventional’ policies to boost inflation, including with negative interest rates. Now two crises, corona and Ukraine, are turning monetary thinking upside down again. It is not yet clear what the new practice will be.