EXCLUSIVE: ECB’s Wunsch: We Must Recognise That the World Has Changed in the Last Three Months

16 November, 2021

By David Barwick – BRUSSELS (Econostream) - The global macroeconomic environment has changed greatly just over the past three months, adding to the uncertainty Europe’s monetary policymakers face, and it would require relatively little in terms of exogenous developments for euro area 2023 HICP to wind up at 2%, European Central Bank Governing Council member Pierre Wunsch said Friday.

In an interview at the National Bank of Belgium, which he heads, Wunsch cautioned against neglecting the possibility that the global economy was witnessing an incipient shift of structural trends that would breathe lasting new life into inflation, and urged that policymakers unflinchingly acknowledge the risk of misjudging how things would evolve.

‘There is now huge uncertainty’, he said. ‘The fact that the world has changed in three months is something we need to recognise.’

Euro area inflation ‘will most probably be above 2% in 2022’, and with a purely ‘mechanical update’ likely to leave the 2023 HICP staff forecast ‘below 2%’, he said, ‘it wouldn’t take much for realised inflation in 2023 to be at 2% - one or two surprises or some second-round effects, so just a fraction of everything we’ve seen in the last three months.’

There is reason to believe that the global economy is undergoing a structural realignment harbouring major implications for inflation, he said, pointing to the potential impact of the climate transition on the natural rate of interest; labour market slack; and the possible fading out of Chinese global disinflationary pressures.

However, not all issues confronting the ECB are external; the ECB realises that the forecasting models it relies on are mean-reverting, in consequence of which ‘we’ve been overestimating inflation for the last seven years’, he said.

'I think we should be symmetric and now recognise that it goes in both directions and that our models risk predicting lower inflation and underpredicting inflationary pressures’, he said. That, he reasoned, argued for attaching more weight to qualitative input such as industry feedback. ‘And companies tell us that the supply constraints are going to last, but also that wage and price pressures are in the pipeline’, he said.

The current constellation of macro elements – including repeated upside inflation surprises, highly supportive monetary and fiscal policies, the climate transition and supply constraints - effectively presented the ECB with a ‘now-or-never’ moment, Wunsch said.

‘This is a huge opportunity to re-anchor to 2%’, he said. ‘We should not miss that opportunity.’

Should re-anchoring fail and medium-term inflation sink back below 2%, this would probably be temporary, he said. ‘If not, we are in big trouble, because I don’t know what the narrative would be’, he said. ‘We would be looking then at ten years of QE and low rates without us reaching our objective. We would then need to ask ourselves existential questions about our framework and what we still believe in.’

The need for some self-searching may ultimately be imposed on the ECB by a proportionality assessment, he observed. ‘And if you need to perform a proportionality assessment in an environment where you believe deflationary forces are so strong that you never reach your objective, you also have a problem, because monetary policy has side effects you have to be able to justify’, he said.

However, Wunsch made quite clear, none of this was tantamount to a desire to see the ECB act with undue haste; on the contrary. ‘I don’t want to make a mistake today by not being patient and then being asked tomorrow to do another five years of QE and negative rates because inflation’s fallen back below 2%’, he said. ‘All of us need to be patient, but we should also not exclude that the inflationary forces are quite strong and at some point will require a reaction.’

‘If we can be patient, we will be, that’s for sure, because we want to re-anchor’, he continued. The ECB must be data-driven, however, and 'cannot afford to say that we want to wait a few years to see if structural forces affecting inflation have changed.’

‘At some point we will have to decide whether we are at target or not, and not say that because we were below target for seven years, we should wait three or four years to make sure we are now really above it’, he added. ‘I’m not sure we will have that luxury.’

The 2023 HICP forecast, now at 1.5% and ‘quite obviously going to be revised upwards’ in December, would clarify little by itself and hence offer scant comfort to monetary authorities, he said. Moreover, ‘the fact that we have committed to give a very important weight to the forecast in our forward guidance is another element I was not very comfortable with,’ he said, referring to his opposition in July, along with Bundesbank President Jens Weidmann, to the ECB’s update of its guidance in line with the new strategy.

‘If you have models that are not performing well - and we’ve seen that they’ve been behind the curve recently - then you probably want to leave more room for discussion around the outcome to set policy’, he explained. ‘Because if energy prices are in backwardation and contribute negatively to inflation in 2023, maybe it’s going to be temporary. If so, and we go back to 2% afterwards, then maybe we should look through that. Looking through energy price developments should be symmetric.’

A discussion of policy should avoid a ‘huge discontinuity between 1.9% and 2%’ when considering the inflation outlook, he said, ‘as this risks being inconsistent with the need for proportionality.’

Wunsch echoed other Governing Council members in rejecting current market rate expectations as unreasonable in light of ECB inflation forecasts. ‘The way I would summarise it is that as of today, there is a very broad consensus that on the basis of our forecast, we don’t hike in 2022’, he said. ‘At the same time, looking at the uncertainty, there is always a tail risk that it could happen.’

At next month’s monetary policy meeting of the Council, the ‘general narrative’ would be an important outcome, but ‘not easy, because we know we are potentially at a crossroads’, he said. It was very important that the ECB signal continued patience alongside open-mindedness, ‘because of the uncertainty, because we know our models don’t perform so well under these circumstances and because we are not sure whether what we are seeing is the beginning of a structural shift or something else’, he elaborated.

Wunsch indicated that he did not regard the ECB as obliged to address all open questions on December 16; indeed, he said, ‘not deciding about everything in December would probably help convey that we want to be patient.’

Developments in the US, where inflation most recently hit a 30-year high, offered the euro area hope, he said, and the ECB might want to stress this more. ‘Having missed the target for the last seven years does justify some caution in our approach’, he said. ‘But at the same time, the latest numbers in the US show inflation recovering very fast there, and if we are faced with the same dynamics, we will then be confronted with a situation where time has shrunk even more.’

As to prospects for economic growth in the euro area, it was ‘very clear’ that if not for high energy prices and supply constraints, the region ‘would be growing faster’, he said. Supply bottlenecks were the more significant headwind now, but the impact of higher energy prices on purchasing power would play the larger dampening role later, he said.

On the other hand, household savings accumulated during the pandemic ‘gives some capacity for consumers to absorb shocks’ and as such would ‘provide a buffer for the higher energy prices’, he said. Moreover, production was probably just deferred to a later date, he said.

‘With this combination of excess savings during the crisis and the fact that the supply constraints will abate - and they will to some extent in 2022 and indeed fully in some sectors – one can hope for a rebound in the production of durable goods’, he said. ‘So, I’m still optimistic that growth is going to be robust in 2022.’

Wunsch stood by his July dissent, citing his reluctance under elevated uncertainty to commit to such specific guidance and noting the possibility of a future conflict with the requirement of proportionality.

‘I was not comfortable with this and would have preferred a clear escape clause’, he said. ‘I put that on the table and there was no majority, and so I dissented. But I did not dissent with our strategy or with our conduct of policy.’

Indeed, what the ECB has done since the pandemic broke out was ‘necessary and important’, he confirmed. ‘Broadly speaking, the ECB’s response to the crisis has been well-managed and also crucial in allowing for a fiscal policy response, as we created conditions conducive to this.’