ECB’s de Cos: Better to Err on the Side of Prolonging Monetary Accommodation

29 November 2021

By David Barwick – FRANKFURT (Econostream) – The transitory nature of inflation is reason to take care not to prematurely remove monetary accommodation in the euro area, and flexibility in conducting asset purchases should be retained, European Central Bank Governing Council member Pablo Hernández de Cos said Monday.

In a speech at a financial conference in Madrid, de Cos, who heads Banco de España, said that higher inflation rates ‘are predominantly temporary in nature and, in the absence of further shocks, should start to subside over the course of the coming year’, though he conceded that they had ‘proved to be stronger and more persistent than anticipated a few months ago.’

The transience of elevated inflation depends on higher input prices not feeding through to HICP, but persistent bottlenecks could cause them to do so, he said. Past rises in intermediate good prices tend to show up with a delay in consumer prices and thus ‘could still contribute to an increase in inflationary pressures on final goods in the coming months’, he said.

Potential second-round wage effects, still subdued, could also prolong high inflation, he said, although the decline in the use of indexation clauses is one reason to think this will not occur. So far, wages increases have also been more pronounced in cyclically stronger sectors, though growing labour scarcity could upend this tendency, he said.

‘In this regard, while excessive wage increases across the board would be counterproductive in the current setting, increases in wages that are consistent with productivity and demand at individual and firm level, respectively, would be welcome’, he said. ‘This would help us to achieve our inflation aim in the medium term, while avoiding undesired second round effects.’

De Cos argued that the economic recovery remained far from complete, real GDP still being well below its pre-pandemic trend. The gap is projected to remain negative for the next couple of years, making it ‘hard to believe that inflation will remain high or even on target in the medium-term’, he said.

Moreover, risks to short-term growth are to the downside, with that posed by the pandemic materialising in some countries, he said. More expensive energy threatens to depress demand and widen the gap between actual and potential output, he said.

Continuing his list of uncertainties around the ‘gradual price normalisation scenario’, de Cos said that the necessary medium-term fiscal consolidation would ‘have an adverse effect on economic growth and inflation’ that ‘is not completely factored into the current macroeconomic projections.’

As for the disinflationary forces of recent years, he then continued, ‘it is very premature’ to think that the factors that have kept wages and prices tame regardless of the degree of cyclical slack will weaken. However, he conceded, the climate transition ‘could, during a transition period, push up energy production costs’, while globalisation may slow, ‘with the knock-on dampening effect on final goods and services.’

Turning to monetary policy, de Cos called the current disparity between supply and demand ‘an argument for keeping financing conditions supportive.’

All in all, ‘we are unlikely to witness interest rate hikes next year or even for some time thereafter,’ the conditions for such tightening being ‘unlikely to be met within that time frame’, he posited.

Between the risks of deferring tightening for too long and tightening too soon, ‘it is better, in my view, to err on the side of caution when it comes to adjusting our monetary policy, and therefore to be patient’, he said, as ‘premature tightening would probably prove costlier, since it could potentially trigger an even larger undershooting of inflation than envisaged at present’.

Still, he acknowledged, ‘we must be on the lookout for any indications of a deanchoring of inflation expectations, since this would be a key factor in making this bout of high inflation endure.’

With respect to the continuation of the pandemic emergency purchase programme (PEPP), de Cos would say only that the Governing Council would decide in December ‘whether the conditions are in place to potentially end net purchases under this programme.’

Keeping the PEPP’s flexibility ‘would be warranted, in the interest of our purchase programme’s efficiency and effectiveness and to provide for a sufficiently nimble response to any situation in which the smooth transmission of common monetary policy across all euro area countries might be compromised, as was the case at the start of this crisis’, he said.