Hubris in Frankfurt

  • The ECB has announced that it won’t tolerate unjustified changes in financing conditions.
  • Neither the ECB, nor any other central bank, can know what unjustified changes are.
  • The ECB’s behaviour opens the door for politicians to interfere in markets as well.

Central banks in most western economies have for many years conspicuously failed to achieve their inflation targets. For much of the time, the failure was ‘from below’, i.e., inflation was below target. This is annoying but, at least assuming no prolonged deflation, it is not dreadful. Now we are back in territory familiar to anyone whose memory stretches back more than 30 years, namely above-target inflation – failing ‘from above’. That is worse, because the consequences of high inflation on households and on economies in general are considerably more harmful than below-target price rises. This is particularly true for pensioners, a large and growing group in all major economies, and hence of particular concern to politicians.

Central banks’ reputation rests on a number of foundations. One is that they understand economics and are capable of performing their tasks (usually keeping inflation low and stable) and achieving their goals.  Another is that by virtue of their independence, they are able to concentrate on their task without the distractions of short-term politics. However, if central banks are seen to be failing at their tasks, the magic can quickly disappear. 

This is suddenly becoming relevant in the euro area. Where the Federal Reserve and the Bank of England (and others) are now seen to be acting resolutely against inflation by tightening monetary policy, the ECB is still standing pat, even as inflation reaches new multi-decade highs.[1]

In addition, the ECB seems to have decided to take on a new task. A 14th June tweet by Isabel Schnabel, a member of the ECB Executive Council states that “We won’t tolerate changes in financing conditions that are not fundamentally justified and that threaten monetary policy transmission”. 

There are some problems here. Above all, fixing asset prices should not be part of the ECB’s (or any other central bank’s) remit. Neither the ECB, nor any other central bank, can know what changes in financial conditions are fundamentally justified or not. Incidentally, what about changes that are somewhat justified – or indeed only somewhat unjustified? How is this to be judged?

Next, assuming that the ECB were to decide that a change in financial conditions – the spread between German and Italian government bond yields, for instance – was indeed fundamentally unjustified, on what basis is it making that judgement? Will it announce what a “fundamentally justified” change is? And are these estimates (guesses, really) fixed or are they likely to change?

Also, how is the ECB going to address fundamentally unjustified changes? Presumably by intervening in markets. This is of course possible. But as the currency turmoil of the 1990s showed, that may not be as easy as it sounds, and even central banks can ultimately be overwhelmed by market forces. (Defenders of proposed ECB action can of course point to Mario Draghi’s famous words “And believe me – it will be enough”; but this was never tested.)

And last (but certainly not least) if the ECB does intervene in markets to fix what it considers fundamentally unjustified changes, when and how will it stop? In other words, when will the central bank stop distorting markets? By announcing a target price and giving markets a one-way bet there?

This raises two further questions. What kind of economy do we live in if the authorities decide the prices of financial assets by fiat? And secondly, by trying to determine fair prices and fix asset markets – something which is very obviously a short-term issue, not a long-term one – the ECB opens the door for politician to do the same. This is even leaving aside that any attempt to fix markets permanently is likely to fail unless it is indeed according to fundamentals, in which case it is unnecessary as markets should adjust on their own. At the end of the day, the ECB’s latest brilliant idea therefore seems to be another example of “imperial over-stretch” – and that always ends badly. For the ECB, the risk is that the aura of omniscience and omnipotence that is so important to central banks, gradually disappears.

Gabriel Stein

[1] How much need central banks actually do? As pointed out in previous Comments, broad money growth is rapidly slowing in the largest advanced economies. Current broad money growth rates imply that inflation will peak in the second half of this year and then fall back sharply in 2023. Some of my fellow monetarists argue that central banks therefore should not raise interest rates. I disagree. In my opinion, central banks need to move policy interest rates from their ultra-low levels back to some form of neutral; and the current time, when it will be perceived to help against inflation, is good. There is of course a risk that central banks will overdo it and raise interest rates by too much.