ECB’s Schnabel: Long-Term Inflation Recovery Needs Accommodation, Tolerance for Overshooting

5 July 2021

By David Barwick – FRANKFURT (Econostream) – Long-term inflation expectations appear to be headed in the direction of the ECB’s price stability objective, but a sustained realignment requires continued monetary accommodation and tolerance for temporary above-target outcomes, European Central Bank Executive Board member Isabel Schnabel said on Saturday.

In a speech at the Petersberger Sommerdialog posted to the ECB’s website, Schnabel said the euro area had ‘embarked on a strong recovery’ and noted the ‘controversial debate’ about where inflation was headed in Europe and globally.

While arguing that temporary factors were behind currently high inflation and that labour market slack would keep medium-term inflation down, she characterised the increase in long-term expectations as suggesting ‘that the exit from the pandemic provides, for the first time in many years, some ground for cautious optimism’ about an escape from European lowflation.

Schnabel dismissed ‘fears of too-high inflation’, offering instead an optimistic vision in which, ‘after a long period of very low inflation, the current spirit of optimism and confidence, in combination with significant public and private investments in digital and green technologies, provide a welcome opportunity for long-term inflation expectations to re-align more closely with the Governing Council’s definition of price stability.’

‘There is growing evidence that this re-alignment is gradually taking place’, she continued. ‘For it to become sustained, monetary policy needs to remain expansionary to avoid choking off the incipient recovery.’

The need to double down on monetary accommodation stems from ‘[y]ears of repeated overprediction of the future path of inflation’, because of which an improved outlook needs to become a clear part of the central scenario and be confirmed by underlying price pressures before justifying ‘a more fundamental reassessment of the medium-term inflation outlook’, she said.

‘Such patience may lead to inflation outcomes being moderately above our aim for a temporary period of time’, she said. ‘This will be a necessary and proportionate requirement to set the conditions to escape low inflation.’

Calling to mind the latest staff macroeconomic projections that foresee HICP of 1.9% this year slowing to 1.5% in 2022 and 1.4% in 2023, Schnabel conceded that ‘[t]here are good reasons to consider this baseline plausible.’

In this context, she cited base effects stemming from energy price developments and the reversal of the German VAT reduction, as well as the expectation that supply would expand over time to meet demand.

‘Uncertainty around the baseline inflation outlook remains, however, exceptionally high at present’ she said with reference to downside risks related to the pandemic, the phasing out of job retention schemes and the possibility that unemployment could limit wage growth and weaken demand.

However, she promptly noted, financial markets tell another story, with option prices consistent with an almost 25% probability of average inflation being in excess of 2% over the next five years, and inflation risk premium estimates indicative of ‘a renewed interest of investors to hedge against the risks of inflation.’

Moreover, she continued, the ECB’s latest survey of monetary analysts reveals considerable perceptions of upside inflation risks this year and next, while the percentage of consumers anticipating higher inflation over the next 12 months than the last is essentially at an almost 20-year high.

These shifts in expectations reflected in part the possibility of greater-than-expected inflationary pressures from the economic reopening, she said. ‘That is, even if supply and demand imbalances will ultimately prove short-lived, they may lift inflation during the transition phase above the levels currently projected’, she said.

Another reason is that ‘the longer demand will exceed supply, the higher the chances that underlying price pressures will gain sufficient traction to break the vicious pre-pandemic circle of low demand and low inflation’, she said. Private and public spending could maintain above-potential demand for some time, she said.

Potential second-round effects are a third factor behind shifted inflation expectations, she said. Although normally regarded sceptically by monetary authorities, in the current environment, ‘a virtuous price-wage spiral may support demand, sustain underlying inflation and thereby help inflation to converge to our aim’, she said.

This depends on labour markets, which currently exhibit ‘very high’ levels of slack, she said. However, skill mismatch and an unexpectedly rapid unwinding of the slack offer reason to think this could change, she said, noting that the IMF sees a slightly positive output gap already next year among advanced economies.