ECB Insight: From No Risk of Inflation’s Durable Return to a ‘New Inflation Regime’ Around 2%

18 January 2022

By David Barwick – FRANKFURT (Econostream) – Do central bankers anticipate economic developments well enough to remain perpetually one step ahead of financial markets and shape monetary policy proactively, or does the lack of any special foreknowledge mean that in fact they essentially go with the flow?

While some observers may ascribe clairvoyant abilities to monetary authorities, this could be due more than anything else to central bankers’ readiness to sound confident in their own predictive ability - even when they emphasise the uncertainty of the environment.

To be sure, in the case of the euro area, there are numerical forecasts that have often enough belied the ECB’s clairvoyance. But the staff forecasts are institutional projections updated only every three months and with little of the room for nuance of comments.

It is at least interesting and potentially instructive to see how comments on a particular topic such as inflation evolve over a certain period and whether policymakers lead or follow developments. To that end, we look specifically at European Central Bank Governing Council member François Villeroy de Galhau, head of the Banque de France.

None of this is to pick on Villeroy, who has been chosen here only because the relative frequency of his public interventions facilitates an examination of their evolution. Villeroy is a knowledgeable and experienced central banker ably backed by an institution with around 10,000 employees, including recognized experts conversant with advanced macroeconomic analysis techniques.

Moreover, Villeroy’s remarks have been thoroughly consistent with those of many of his colleagues as well as peers from other jurisdictions. In this context, it is worth recalling that it was only at the very end of November that US Federal Reserve Chairman Jerome Powell finally declared it ‘probably a good time to retire’ the word ‘transitory’ that had been heavily relied on to characterise inflation rates that continue to mount even faster and further in the US than in Europe.

A bit under a year ago, Eurosystem staff were projecting euro area HICP of 1.0%, 1.1% and 1.4% in 2021, 2022 and 2023, respectively. The US had just registered annual CPI of 1.4% in January, unchanged from the previous month and well below target. The corresponding Eurozone reading was a much weaker 0.9%, though that represented a significant increase after -0.3% in each of the four previous months.

Still, against the backdrop of various factors including an outsized US stimulus then on the table, policymakers, Villeroy naturally among them, were well aware of the question whether inflation would show unaccustomed signs of life.

‘To speak today of overheating and a lasting recovery in inflation in the United States seems premature to say the least; and there is no such risk in Europe’, he said on February 19 of last year.

Ten days later, on March 1, Villeroy’s confidence in the tameness of European inflation was unshaken – perhaps also because February annual HICP had held reassuringly steady at 0.9% - but he was already more reserved when it came to US developments. The euro area’s economic situation is different from that of the US and ‘[t]here is no risk of overheating in Europe’, he said.

Not much later, on March 12, Villeroy again rejected ‘any risk of inflationary overheating in Europe’ but explicitly acknowledged the spillover to Europe of the effect of overheating concerns in the US.

That was the day after the Governing Council had decided to address this spillover by accelerating asset purchases and new euro area staff macroeconomic projections had been released calling for upwardly revised HICP of 1.5% and 1.2% in 2021 and 2022 and an unchanged 1.4% in 2023. One day before that, US CPI for February had come in at a still mild but clearly higher 1.7%.

On March 24, Villeroy ceded a bit more ground, concurring that US fiscal ‘support can provoke an acceleration of prices in the United States’, but he maintained that ‘the situation in Europe is completely different’, so that ‘we don’t see any risk of inflationary overheating’ – at least, ‘on average’.

Nine days later, with euro area inflation up to 1.3%, Villeroy cited ‘many US economists’ as having raised the possibility of economic overheating on their side of the Atlantic as a result of the new fiscal stimulus.

That remained the tenor of his comments on the subject for the next few months. Inflation in the US? Yes, or at least maybe. Inflation in Europe? No – here is different.

For example: ‘The current debate about a possible return of inflation may be legitimate in the US, but not in the euro area’, Villeroy said on April 13, the day CPI figures showed US inflation had accelerated to 2.6% on the year in March.

He remained on message five weeks later, against the backdrop of newly risen April inflation readings of 4.2% in the US and 1.6% in the euro area. ‘There is not today any risk of a durable return of inflation in the Eurozone and thus there is no doubt that the monetary policy of the ECB will remain very accommodative for a long time’, he said on May 18. Europe is ‘in a different situation, including the economic cycle, which is more advanced in the United States’, he said.

And again on May 25: ‘Our monetary policy can be patient, as inflation in the euro area is significantly lower than in other jurisdictions.’ Indeed, he repeated, there is no current risk that euro area inflation would recover sustainably.

June 10 was not only the day the ECB boosted its staff inflation projections to 1.9% in 2021 and 1.5% in 2022, leaving 2024 at 1.4%. The lion’s share of financial market attention probably went to the announcement of May CPI in the US of 5%, a 13-year high and ‘a number that was striking’, Villeroy remarked the next day.

But European HICP was only 2% in May, so ‘that’s them, and we’re us’ with respect to inflation on the two side of the Atlantic, he continued to maintain. The ECB can therefore be ‘at least as patient’ as the Fed, ‘because the inflation situation is different in the Eurozone’.

On June 14, he noted again ‘much higher’ US inflation, but declared: ‘I don't believe in the risk of transatlantic contagion on inflation.’

Such an avowal calls to mind European central bankers’ assurances some 13 years ago that the euro area had ‘decoupled’ from the US sufficiently to protect the former from subprime-related developments in the latter, assurances quickly revealed to be little more than wishful thinking.

Villeroy might have invoked Eurosystem staff forecasts to defend his claim, uttered over the course of months, that there was no risk of inflation recovering lastingly in Europe. After all, the projection for 2023 headline inflation emerged from the March and June forecast exercises unchanged from the 1.4% of the original publication in December 2020.

His claim might however exceed the limits of a more cautious reading of the forecasts, especially taking into account the uncertain environment and given that all three measures of 2023 core inflation estimated by the ECB were revised upwards in both March and June.

Subsequent forecast rounds indeed led to significantly more robust readings, so that HICP in 2023 – and meanwhile 2024 as well – is now projected at 1.8%, an upgrade of inflation prospects that occurred amidst criticism by Governing Council members that ECB staff forecasts suffer from mean reversion. The systematic underestimation of inflation said to result from this was thematised at the October 27-28 policy meeting.

By December 17, the day after the last monetary policy meeting of the Council, Villeroy’s tune had changed dramatically. He referred to the new 2023 and 2024 inflation forecasts as being ‘around 2%’ and meaning ‘something important that has perhaps not been stressed enough.’

‘It is that after the [inflation] bump, which once again we take seriously, we are not returning to the pre-Covid regime, remember, of very low inflation’, he explained. ‘There is in some ways a new inflation regime around the 2% target.’

The difference between the projection of 1.8% and the ECB’s price stability goal of 2% shouldn’t be given ‘undue importance’, he added. ‘This is the margin of uncertainty at the forecast horizon of 2024.’

That is quite the about-face. Of course, no one should expect or want monetary authorities to continue to deny the possibility of a lasting recovery of inflation in Europe if available information supports such an expectation, as it increasingly does.

But his and many others’ initial dubiousness about the outlook even for US inflation (up in the meantime to a 40-year high of 7.0% in December), let alone European, followed by a piecemeal concession to the reality on the ground, underscores that ECB Governing Council members are not necessarily any better prognosticators than other observers.

But then, central bankers are not equipped with crystal balls. That is a particularly unfortunate deficit of their arsenal when economic paradigms are apparently shifting (‘a new inflation regime’, as Villeroy put it), because that is when monetary policy is most at risk of falling behind the curve as its practitioners erroneously assume that they know what awaits.

Given which, it is not entirely surprising that a heightened awareness of just such a risk is an important element of the present situation; developments have forced the ECB to acknowledge relatively hurriedly that prospects for a return to price stability are not nearly as far out of reach as its representatives were declaring just a few months ago.

The ECB is hardly alone in this respect. There have been some who sounded the inflation alarm relatively early, but there also remains a hard core of Governing Council members profoundly reluctant to shift with the outlook. Villeroy, to his credit, is at least not one of the latter.