The writer is head of macro research at the BlackRock Investment Institute
Europe is changing its rule book. The European Central Bank presented a new monetary policy strategy last autumn and is putting it to the test this year.
That comes as discussions about reforming Europe’s fiscal framework are getting under way under the French EU presidency. Changes are needed.
Disbursements from the Next Generation EU economic recovery programme and suspended rules on deficits have allowed the fiscal stance of the bloc to be smoothly recalibrated this year to support spending. But the reapplication of the EU’s deficit rules under Stability and Growth Pact again next year would reintroduce excessively tight fiscal policy. This would raise questions about the level of stimulus that can be provided by the ECB.
Despite its new framework, the ECB is struggling to navigate the post-pandemic restart. The surge in inflation has sparked lively discussions about the need for a policy adjustment by the central bank.
While the US Federal Reserve will raise rates soon and start whittling down its balance sheet later this year, the ECB has ruled out increasing rates this year and instead plans to provide further stimulus through its quantitative easing programme of asset buying. The minutes of the December meeting show increasing disagreement on the governing council though and next week’s ECB meeting will be closely watched for changes in the guidance.
Parallels have been drawn with the measures taken by the Bundesbank in the early 1990s, when Europe last experienced inflation this high. Such comparisons overlook that the inflation drivers are completely different today. Instead of exuberant demand in the wake of German reunification, today’s inflation is mostly due to supply constraints amid the post-pandemic activity restart.
The pandemic is likely to have increased the European labour market mismatch between job openings and job applicants in terms of locations or qualifications. Yet any resulting wage increases are part of the adjustment process in a market economy, and not necessarily signs of a wage-price spiral being set in motion.
Exactly how long the current inflation surge will last is difficult to predict, especially in the light of rising geopolitical risks concerning the Russia-Ukraine conflict. Fortunately, the ins and outs of the near-term inflation dynamics are not the key point in the policy debate. What matters is the fact that euro area inflation dynamics are driven by shifts on the supply of goods and services. Clearly, tighter monetary policy by the ECB would not resolve supply-side bottlenecks in, say, the German car industry. Instead, the ECB’s policy should support the required reallocation of resources by explicitly accepting inflation overshoots.
This notion goes beyond the pandemic: it also applies to the transition to net zero. Decarbonising the European economy requires big shifts in resources towards low carbon sectors. In addition, it requires massive public investment spending.
Plans submitted for Next Generation EU funding show that measures to help the bloc meet its object of becoming carbon-neutral by 2050 are above-target, but they still fall short of the required spending. Early action is crucial. Only an orderly climate transition makes climate-related supply shifts predictable and spreads them over a long period, thus limiting the inflation impact.
While energy prices could continue to cause upward pressure on inflation, as ECB executive board member Isabel Schnabel recently highlighted, staff projections still put medium-term inflation close to, but below, 2 per cent. And with inflation expectations remaining anchored below, the ECB can afford to look past energy price spikes.
As the ECB debates policy normalisation, governments are discussing potential reforms to Europe’s fiscal rules. For the ECB, memories still linger of the 2011 policy error raising rates on the back of rebounding energy prices. The same is true for the self-defeating fiscal austerity around the same time that materially slowed the European recovery from the global financial crisis.
One way to reflect the secular decline in interest rates would be to raise debt limits, as Klaus Regling, head of the European Stability Mechanism, has proposed. Another way would be to extend the timeframe over which countries are expected to converge to the Growth and Stability pact rules. The Next Generation EU programme is an important step towards a collective fiscal response. But European governments cannot afford to stand still on national fiscal policies either.