By Hans Bentzien
JACKSON HOLE (Dow Jones) — The European Central Bank (ECB) must take decisive action to combat very high inflation, according to ECB Director Isabel Schnabel. Schnabel told the Jackson Hole monetary policy symposium that when the persistence of inflation is unclear, the central bank must act forcefully, whether the shock is a supply-side or demand-side shock.
“When a central bank underestimates the persistence of inflation – as most of us have done over the past year and a half – and is slow to adjust policy as a result, the costs can be significant,” Schnabel warned.
The ECB Director sees another reason for the central bank reacting decisively to increased inflation in cases of doubt in the need to maintain or win public trust. “Surveys suggest that rising inflation is beginning to weaken confidence in our institutions. Young people in particular have no vivid memory of central banks fighting inflation,” Schnabel said.
The ECB is observing a steady and sustained increase in medium- and long-term inflation expectations among parts of the population, which entails the risk that inflation will persist beyond the initial shock. The ECB director pointed out that medium-term inflation expectations had risen to 3 to 5 percent and long-term to 2.2 percent.
According to Schnabel, two explanations for the increase in inflation expectations suggest themselves: “One is that the higher medium-term inflation expectations could be due to the perception that the monetary policy reacted too slowly to the current high inflation,” she said.
A basic principle of optimal monetary policy when inflation is above target is to raise interest rates by more than the change in expected inflation – the Taylor principle. “If real short-term interest rates don’t rise, monetary policy is ineffective in dealing with high inflation.”
A second possible explanation, according to Schnabel, is that the higher inflation expectations reflect more fundamental concerns, perhaps related to the dominance of fiscal and fiscal policies, or the recent review of central banks’ monetary policy framework, which focuses more on the challenge of being too low than one focused on high inflation.
“All of these factors may have led to higher inflation tolerance and stronger desire to stabilize output,” said the ECB governor. Decisive action is needed to break this perception. “When uncertainty about our response function undermines confidence in our commitment to maintaining price stability, a cautious approach to policy making is no longer the way forward.”
Finally, Schnabel offered a third argument in favor of central bank action: If they act too late, the costs of this hesitation could be even higher than in the 1980s. Reasons for this are the lower interest rate sensitivity of the national economies, the weaker connection between unemployment and inflation and the greater relevance of global factors for the development of inflation.
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(END) Dow Jones Newswires
August 27, 2022 2:14 PM ET (6:14 PM GMT)