Unhappy ECB

  • In theory, the ECB should find it easier than most central banks to fight inflation. 
  • In fact, it is finding it more difficult, preferring to do nothing and rely on Mr Micawber’s dictum.
  • This is partly because the ECB is in a process of transition, from ‘Teutonic’ to ‘Latin’.

All happy central banks are alike; each unhappy central bank is unhappy in its own way (with apologies to Leo Tolstoy).

This is turning out to be a literary piece. However, the literary allusions are, we believe, apt.

As the world enters 2022, the WHO holds out hope that COVID will finally shift from pandemic to endemic by mid-year. Instead, high and accelerating inflation in most advanced economies is rapidly coming to the fore as the key issue facing economic policy decision makers. In the United States and the United Kingdom, the thought that inflation is “transitory” and will subside of itself, is no longer heard. The Bank of England has already raised interest rates and the Federal Reserve is poised to do so. True, as pointed out in a previous Comment, as long as real interest rates remain substantially negative, the impact on inflation will be limited; but it is at least a start. If a happy central bank is one that is or is at least on the way to achieving its target, then inflation-targeting central banks that are tightening monetary policy in order to bring down above-target inflation, should fell at least somewhat happy.

However, there is one glaring exception to this happiness. That is the European Central Bank. Here, the view that inflation is temporary and will fall back to target of itself, still reigns supreme. This is peculiar. The ECB is by far the most securely independent central bank in the world. The Chairman of the Board of Governors of the Federal Reserve can be told by the President of the United States to stop worrying about the (relatively small) number of unemployed and start worrying about the (very large) number of employed who are suffering from inflation. But the ECB, with its independence set out in an international treaty, is on the whole shielded from such pressure. If anything, the history of the euro area rather shows the central bank scolding politicians and urging them towards fiscal probity.

So why is the ECB so reluctant to act on inflation? Part of the reason may be that the ECB is actually in the process of transition. When the ECB was set up, it was consciously modelled on the Bundesbank and domiciled in Frankfurt. This was partly to assuage the well-known German aversion to inflation. But it was also because the ECB was supposed to be a ‘Teutonic’, inflation-wary, prudent, rule-driven central bank. However, it is now well on the way to becoming what one might call a ‘Latin’ central bank: less driven by rules than by flair and ad hoc decision-making, certainly not enamoured by inflation, but acutely aware of the damage that acting on the anti-inflationary rhetoric would do to the national economy. This is a topic that we will cover in a follow-up piece next week.

Meanwhile, in the year to November, German inflation reached a 39-year high of 5.3%, having been above the 2% target since April. For the EA as a whole, inflation hit 4.7% in November, while producer price inflation is above 20% (year to October). This ought to be reason for substantial ECB unhappiness and moves long since to bring inflation down to target. After all, when German inflation was last at these levels, the Bundesbank’s official lending rate was 7.5%, a rather different response than the ECB’s current 0.0%. The call for action should be even more clear since the ECB loudly proclaims that it has not adopted the American idea of ‘average inflation targeting’, i.e., accepting a temporary (dare we say ‘transitory’?) overshoot to compensate for past undershoots. (By the way, the ECB’s claims not to practice AIT seem somewhat disingenuous, in view of developments on the ground and comments relating to those developments.)

In fact, the ECB’s actions are not as puzzling as they seem. One of the key features of the pandemic has been a surge in government debt, notably (though not exclusively) in southern Europe. According to The Telegraph, France’s debt/GDP ratio is currently 118%; Portugal’s is 135%; and Spain’s is 120%. Much more worryingly, Italy’s is 155% and Greece’s debt/GDP ratio, after repeated restructurings and write-offs, is 206%! Simply put, raising interest rates will rapidly erode the viability of government finances in many of these countries. (It would also erode the value of the bonds purchased by the ECB, thus threatening its equity and potentially forcing it to ask member governments for a capital injection. This is not crucial but would be embarrassing and possibly infringe on its independence.)

So what is an unhappy central bank to do? For the moment, the ECB seems content to adhere to Mr Micawber’s dictum. Mr Micawber, as readers may recall, was the serial financial failure in Charles Dickens’ novel David Copperfield, whose constant motto in the face of adversity was ‘Something will turn up’. As it happens, it did; he was transported to Australia and became a success there. But David Copperfield is a work of fiction.

In the meantime, monetary data do not support the view that EA inflation will slow on its own. True, EA broad money growth (M3) has come down from a peak of 12.5% in January 2021, to 7.3% in the year to November. But this is still well above pre-pandemic rates. Moreover, on three- and six-month annualised bases, a better guide to recent trends, M3 growth is accelerating again, this time accompanied by a pick-up in bank lending to the non-bank private sector, notably housing loans. As yet, this rise in credit is not particularly strong (roughly back to pre-pandemic levels), more of a straw in the wind. But the important point is that, as long as real interest rates remain negative and as long as broad money growth remains at current rates (let alone accelerates), there is no reason why inflation should subside of itself. 

How will continued decades-high inflation go down in Germany? Presumably not very well. But what can and will Germany do about it? Events ever since the Great Recession have shown that Germany’s clout in the ECB is very limited, with policy frequently taking turns that the German representatives (always two, the President of the Bundesbank and one member of the ECB Executive) are unhappy with but cannot change. Germany could of course leave the euro; but that is a nuclear option. Short of that, the only option is to perhaps not grin, but at least bear it.

Something may indeed turn up and save the ECB from having to make a choice, whether fighting near-term inflation at the cost of wreaking fiscal havoc; or allowing inflation to continue and risk it becoming entrenched. But a far more likely outcome is that, at some stage, probably before mid-year, the ECB will have to make an active choice. And that choice will by then almost certainly be to withdraw the monetary stimulus completely and begin to tighten policy. Whether that will bring happiness to the euro area, is a different issue.