Opinion

Three headaches for the European Central Bank

Even though inflation in the euro area is lower than in the US, three issues make it a lot more difficult for the ECB to control inflation and preserve financial stability. Once again, the limits of EMU architecture are visible and will require a rethink.

By: Date: May 31, 2022 Topic: European governance

This opinion was originally published in Money Review and El Economista.

In its latest forecast published on 16 May, the European Commission expects inflation in the euro area to be 6.1% and growth 2.7% in 2022. The last forecasts published by the ECB on the 10 March, predicted inflation and growth at 5.1% and 3.7% respectively. These are big revisions for such a short time span and they of course reflect the implications of the war in Ukraine.

The inflation and GDP growth outlook for the euro area gives the European Central Bank three issues to worry about.

The first headache that the ECB faces is that unlike in textbooks, inflation and output are now moving in opposite directions. This implies a trade-off, meaning ECB policy to tame inflation will necessarily make output deteriorate further. Many now talk about stagflation in the EU and euro area. There is some truth to this, as countries and the bloc will face weak growth and persistent inflation for some time.

However, it is also worth noting that the degree of stagflation, in other words the weakness of growth on the one hand and inflation pressures on the other, are nowhere near the stagflation of the early 80s. Back then, countries like France and Spain faced inflation rates of over 10%, even 20% in the case of Italy, as well as negative growth. The highest country inflation rate that we expect to see in the euro area this year is 6% and no country will grow by less than 1%. It is therefore a much lighter form of stagflation.

The second headache that the ECB faces has to do with inflation dispersion. Figure 1 plots the HICP inflation and two alternative definitions of core inflation, since the start of European Monetary Union in 1999. We observe three main peaks in the data. The first peak appears at the start of EMU and lasts about a year, the second peak at the start of the financial crisis lasts over 3 years, and the last is ongoing.

While the peaks are comparable in size, the reasons for them are different. Divergence during the financial crisis reflected the build-up of macroeconomic imbalances. However, the current differences in inflation reflect differences in geopolitical dependencies in terms of the energy mix and also in the energy intensity of production. On both occasions however, these divergences reflect structural differences in the economy and their (lack of) resilience to the running shock.

The third headache has to do again with country discrepancies but this time with the widening of country spreads that are already increasing. We know that country debts do not all reflect the same amount of risk. And in times of turbulence country spreads move to reflect this. However, this time is different in that it is monetary policy itself that is about to trigger this financial fragmentation.

Until now, and for as long as monetary policy had been expansionary, the objectives of price and financial stability were served simultaneously. However, now the ECB is about to come to the contractionary part of the monetary policy cycle, the objectives of price and financial stability push in opposite directions. As interest rates increase to tame inflation, the spreads between countries are going to increase, causing servicing costs to diverge between countries.

Given the non-negligeable weight of sovereign bonds in domestic banks’ balance sheets, heightened spreads can lead to financial instability. And in any case, diverging interest rates impairs the monetary transmission channel, which in turn threatens price stability and ultimately the single currency itself.

The ECB does not have suitable ready-made tools to apply directly. Given how important financial stability is for the euro area it must seek ways to at the very least neutralise the extent of the increase in spreads that itself triggers.

Even though inflation the in the euro area is lower than in the US, the three issues described make it a lot more difficult for the ECB to control inflation and preserve financial stability. Once again, the limits of EMU architecture are visible and will require a rethink.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to [email protected].

Read article More on this topic More by this author
 

Blog Post

The implications for public debt of high inflation and monetary tightening

Expected increases in interest rates and reductions in real GDP growth rates will result in relatively small increases in public debt-to-GDP ratios, but inflation will reduce debt ratios very substantially

By: Zsolt Darvas Topic: Macroeconomic policy Date: June 29, 2022
Read article More by this author
 

Blog Post

European governance

Discretion lets Croatia in but leaves Bulgaria out of the euro area in 2023

Crucial decisions about whether a country can join the euro area depend on questionable discretionary decisions.

By: Zsolt Darvas Topic: European governance, Macroeconomic policy Date: June 22, 2022
Read article More on this topic
 

Blog Post

A new European tool to deal with unjustified rising spreads

The European Central Bank needs a new tool to prevent the current rise in spreads, triggered by monetary policy tightening, from escalating into a new euro-area crisis.

By: Grégory Claeys and Maria Demertzis Topic: Banking and capital markets Date: June 20, 2022
Read article Download PDF
 

External Publication

European governanceEuropean Parliament

Fragmentation risk in the euro area: no easy way out for the European Central Bank

The ECB should design a specific tool that will accompany interest rate hikes to neutralise the risk of fragmentation directly for countries facing it, staying within the bounds of the EU treaties and ensuring political legitimacy. We also advocate structural changes to the ECB’s collateral framework to avoid unnecessary uncertainty surrounding the safe asset status of European sovereign bonds.

By: Maria Demertzis, Grégory Claeys and Lionel Guetta-Jeanrenaud Topic: European governance, European Parliament, Testimonies Date: June 8, 2022
Read article More on this topic More by this author
 

Podcast

Podcast

Taming inflation?

What are the implications of prolonged inflation?

By: The Sound of Economics Topic: Macroeconomic policy Date: May 25, 2022
Read about event More on this topic
 

Past Event

Past Event

How are crises changing central bank doctrines?

How is monetary policy evolving in the face of recent crises? With central banks taking on new roles, how accountable are they to democratic institutions?

Speakers: Maria Demertzis, Benoît Coeuré, Pervenche Berès, Hans-Helmut Kotz and Athanasios Orphanides Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 11, 2022
Read about event More on this topic
 

Past Event

Past Event

What is in store for Euro area economies?

ECB Executive Board Member Philip Lane discusses the outlook for Euro area economies.

Speakers: Maria Demertzis and Philip Lane Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 5, 2022
Read about event More on this topic
 

Past Event

Past Event

Tackling future risks to banks

How to address vulnerabilities in banks in the coming years?

Speakers: Maria Demertzis and Elizabeth McCaul Topic: Banking and capital markets Date: March 29, 2022
Read article
 

Opinion

European governance

How to reconcile increased green public investment needs with fiscal consolidation

The EU’s ambitious emissions reduction targets will require a major increase in green investments. This column considers options for increasing public green investment when major consolidations are needed after the fiscal support provided during the pandemic. The authors make the case for a green golden rule allowing green investment to be funded by deficits that would not count in the fiscal rules. Concerns about ‘greenwashing’ could be addressed through a narrow definition of green investments and strong institutional scrutiny, while countries with debt sustainability concerns could initially rely only on NGEU for their green investment.

By: Zsolt Darvas and Guntram B. Wolff Topic: European governance, Green economy, Macroeconomic policy Date: March 8, 2022
Read article More on this topic More by this author
 

Opinion

The week inflation became entrenched

The events that have unfolded since 24 February have solved one dispute: inflation is no longer temporary.

By: Maria Demertzis Topic: Macroeconomic policy Date: March 8, 2022
Read article More on this topic More by this author
 

Opinion

The weakness of average inflation targeting

Introducing average over time without defining what this means is counterproductive and current levels of inflation in the US will sooner or later expose this weakness in the Fed’s new strategy.

By: Maria Demertzis Topic: Macroeconomic policy Date: February 22, 2022
Read article Download PDF More on this topic More by this author
 

External Publication

Book notes: Monetary policy in times of crisis

Review of 'Monetary policy in times of crisis: a tale of two decades of the European Central Bank' published in the Central Banking.

By: Francesco Papadia Topic: Macroeconomic policy Date: February 17, 2022
Load more posts