Exclusive: ECB Policymakers Unwavering in Support for Tighter Monetary Policy

5 July 2022

Exclusive: ECB Policymakers Unwavering in Support for Tighter Monetary Policy
- ECB insider: ‘Hard to imagine a substantial improvement in the inflation outlook’
- ECB insider: ‘I see only upside risks, not downside risks’
- ECB insider: ‘Might be a need for stronger action from the central bank’
- ECB insider: Could be dangerous to do less than what our HICP projections assume
- ECB insider: Stagflation ‘would still require raising interest rates anyway’

By David Barwick – FRANKFURT (Econostream) – The recently somewhat weaker economic context is far from diminishing the resolve of the European Central Bank to tighten monetary policy, based on recent insights by Econostream into the thinking of ECB insiders.

Policymakers’ determination to proceed full steam ahead on the normalisation course puts paid to speculation that the tone of urgency with which rate hikes are being bandied about is born of concern that the current window of opportunity to increase borrowing costs will start closing, and seems instead to reflect growing fears about where inflation is headed, regardless of a possible cut-off of Russian energy.

‘I mean, it’s, it’s a minimum of six months in a row that we’ve been surprised by inflation’, said one Council member who was speaking before June HICP came out. ‘If it continues, there will be more and more pressure for more decisive policy.’

In theory, this person conceded, it was possible that an economic slowdown could cause inflationary pressures to subside. But in practice, ‘it’s hard to imagine a substantial improvement in the inflation outlook’, he said. ‘I see only upside risks, not downside risks.’

At the June 8-9 Council meeting, ‘nobody was mentioning downside risks, it’s only upside’, he continued in the same vein. It wasn’t simply that risks existed, but rather, ‘if you look back, all those upside risks materialised’, he said.

Inflation coming from energy has ‘broadened a lot’, he continued. ‘There are first signs that expectations might change. Employment is improving a lot. Unemployment decreased to record levels. Wages are still more or less growing at the same level, but there were many one-off payments to compensate inflation. There are hints, you can say it like this, that pressure coming from inflation might increase. So, many upside risks.’

Another ECB insider urged keeping in mind the surprisingly strong recovery in the wake of the pandemic, arguing that the adaptive capacity exhibited by euro area economies then ‘may surprise us again on the upside.’

Like the first person, this person also noted that regional labour markets were ‘very strong’. This by itself meant that Europe’s situation was ‘very far from the stagflationary scenarios of the past’, and in addition, balance sheets were solid and accumulated savings remained high, he said.

If Russia were to stop the flow of energy to Europe entirely, that would cause a recession, but even so, the slump would be ‘relatively short-lived’, he said, as economies would switch to other sources of energy and implement intelligent rationing to cushion the impact.

It was ‘very clear’ that monetary policy normalisation needed to continue, he said, and ‘we all agree’ that price stability constitutes the ECB’s best possible contribution to growth anyway. The longer elevated inflation persists, the greater the probability that expectations will dis-anchor and wage earners will demand to revisit agreements, he said.

‘The shift to a higher inflation regime can happen’, he warned. This can occur in a matter of months, but once it takes place, undoing it is a question of years, he said.

A third ECB insider acknowledged downside risks to growth, in particular in conjunction with high European dependence on Russian energy, but like the second person, rejected stagflationary fears.

Simply put, stagflation over any significant amount of time would mean that the central bank was not fulfilling its mission with respect to inflation, he reasoned, and that could not occur.

‘But at the same time, I don’t think we should discount the possibility of inflation becoming more persistent than we currently assume, so that there might be a need for stronger action from the central bank’, he said.

That was an argument for not delaying policy normalisation, he noted, as the possible need otherwise ‘to tighten even more later’ would wind up taking a greater economic toll.

This person explicitly dismissed the suspicion that calls from some quarters to frontload ECB rate hikes were driven by the fear that the ship of normalisation could run out of steam faster than foreseen due to economic softness.

‘I think the primary consideration for me at least is still what we see happening to inflation’, he said. ‘You need to react to get inflation under control. And even looking at the latest projections, now you could argue that there seems to be more problems still with energy, so things might be even worse.’

Already embedded in the ECB’s current euro area inflation forecast of 2.1% in 2024 is ‘quite significant tightening’, he observed. ‘So, I think it would be perhaps dangerous to do less than that, because that would imply that the situation might be even worse.’

Only the fourth and last ECB insider was, without being dovish by any means, willing to suggest that a questionable economic outlook supported hiking without delay. If the Eurozone economy were to weaken ‘more significantly than expected’, he said, ‘then of course being careful with interest rates is important.’

However, he quickly qualified this, noting that with interest rates currently ‘way below’ neutral, the ECB could go ahead and hike boldly in any event. Even the ‘worst outcome’ of a stagflationary episode ‘would still require raising interest rates anyway’, he pointed out.

Hiking rates promptly was all about reining in expectations, he said. ‘We can prevent second-round effects when these energy and food shocks gradually fade’, he said.