ECB Insight: Schnabel Acknowledges Possibility of Inflation Recovery

5 July 2021

By David Barwick – FRANKFURT (Econostream) – European Central Bank Executive Board member Isabel Schnabel’s speech over the weekend represents a tentative but important acknowledgment of the potential for euro area inflation to stage the kind of sustainable recovery monetary policymakers had until now seemed to discount.

Not surprisingly, Schnabel by no means turned the ECB’s currently conventional view of medium-term inflation completely on its head, calling it ‘likely to remain below the Governing Council’s aim’ for the standard reason that ‘the large prevailing labour market slack is receding only gradually’.

However, her characterisation of the uncertainty around that baseline inflation outlook as ‘exceptionally high’ was markedly lacking in the confidence of other Governing Council members’ more categorical unwillingness to entertain the idea of significant upside surprises beyond the short run.

And while she duly recounted the downside inflation risks – the pandemic with its mutations, the phasing out of employment support and potentially weaker-than-expected wage developments – Schnabel was visibly keen to note financial market developments suggestive ‘for the first time in many years’ of a possible end of the lowflation era.

In addition to market-based evidence including option prices, inflation risk premium estimates and heightened demand for inflation-protected bonds, she cited the ECB’s latest survey of monetary analysts as well as consumer surveys showing the share of consumers anticipating inflation over the next 12 months to increase more rapidly than it did over the past 12 months to be in effect at a nearly two-decade high.

But Schnabel also argued that such expectations were not without reason, pointing to possibly greater-than-expected inflationary pressures from economic reopening; the potential against the backdrop of elevated post-pandemic demand for underlying pressures to ‘break the vicious pre-pandemic circle of low demand and low inflation’; and the possibility of second-round effects taking hold.

Despite currently subdued wage developments, she said, ‘[t]wo factors might, however, strengthen the bargaining power of workers in the recovery from the crisis’, namely a skills mismatch in the context of structural economic changes and ‘a faster and broader pace of reabsorption of current labour market slack.’

None of this would justify ‘fears of too-high inflation’, though, she hastened to add, as euro area inflation ‘would very likely remain well below the levels that threatened price stability, and hence welfare and social cohesion, in the 1970s and 1980s’.

That Schnabel chooses those two decades as her frame of reference is not entirely comforting, annual German CPI throughout the 1970s and until late 1984 having been far to the north of the ECB’s definition of price stability.

Be that as it may, she conjured up a vision in which ‘the current spirit of optimism and confidence’, flanked by digital and green investment, provided ‘a welcome opportunity for long-term inflation expectations to re-align more closely’ with the ECB’s price stability objective. ‘There is growing evidence that this re-alignment is gradually taking place’, she added.

Still, Schnabel did not appear to envision any ramifications of this for monetary policy in the foreseeable future. On the contrary, her prescription for such a realignment to become sustained was that ‘monetary policy needs to remain expansionary to avoid choking off the incipient recovery.’

This she portrayed as a consequence of the hole the ECB had dug itself into through ‘[y]ears of repeated overprediction of the future path of inflation’, which had raised the bar for a ‘more fundamental reassessment of the medium-term inflation outlook’.

The wait to see whether underlying inflation dynamics indicate a sustainable recovery of inflation may encompass headline HICP ‘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.’

Where does this leave us? On the one hand, the chances of durably higher inflation down the road are greater than previously assessed by the ECB. On the other, this prospect puts an even higher premium on current monetary policy accommodation, as a tightening would jeopardise the outcome we all long for. And between now and the day when the lowflation era can be declared over, above-target HICP will be a welcome indication that we are on the right path.

Something for everyone.