ECB Insight: Single-Minded Focus on Inflation Likely to Come Under Pressure as Growth Slows

29 July 2022

By David Barwick – FRANKFURT (Econostream) – As the Eurozone’s economic weakening becomes more apparent, the question of whether or indeed when the ship of monetary policy normalisation might start running out of steam becomes more pressing.

 

It was only early this month that we wrote that conversations with insiders indicated that ‘[t]he recently somewhat weaker economic context is far from diminishing the resolve of the European Central Bank to tighten monetary policy’.

 

It is fair to ask to what extent this remains the case. On the basis of policymakers’ latest public comments, there are already grounds to think that their resolve is subject to strain.

 

Officially, of course, the ECB would be more consistent if slow growth affected policy-making only on the same basis on which the exchange rate, for example, also enters into its calculations: via the impact on inflation.

 

That is why, speaking at last week’s press conference, President Christine Lagarde responded to a question about how monetary authorities would react to stagflation by first reminding of the ECB’s primary mandate and ultimately stating that ‘what we have to do is act in relation to inflation given the circumstances. That's what we are doing.’

 

And this is why Vice President Luis de Guindos in an interview published today also recalled the ECB’s price stability mission and stressed its commitment to this when faced with slower growth and high inflation. ‘Therefore, the main factor that will guide our decisions will be the evolution of inflation’, he said.

 

Not surprisingly, Bundesbank President Joachim Nagel, asked in an interview appearing last Friday essentially the same question as Lagarde the day before, gave an answer cut from the same cloth, invoking medium-term price stability and conceding downside risks to growth while arguing that current forecasts did not indicate an actual economic slump.

 

But other non-Executive Board members of the Governing Council have not been so categorical. That naturally includes relatively dovish members first and foremost. These will be the first to balk at further rate hikes when the economy flounders.

 

‘There is a risk of a recession’, Banca d’Italia Governor Ignazio Visco said yesterday, in which case the ECB would ‘need to discuss what to do.’ Still, he separately suggested that darkening growth prospects weren't so grim as to force the Governing Council to abort its tightening plans after September, because monetary conditions were still very loose.

 

Also at the dovish end of the spectrum, Bank of Greece Governor Yannis Stournaras on Wednesday explicitly tied ECB policy normalisation to the economic outlook as such. ‘If the world economy, and especially the European economy, goes into recession, starting in '23, don't be surprised if we start having central bank interest rate cuts starting in '23, not increases’, he said.

 

Their like-minded but more cautious colleague, Banco de España Governor Pablo Hernández de Cos, said one week ago today that the pace of normalisation ‘depends precisely on economic developments and in particular, obviously, on the dynamics of inflation. And of course also on the macroeconomic situation, on economic growth, because economic growth also has economic implications for inflation.’

 

Other things he similarly failed to enumerate also have implications for inflation, and having already cited inflation explicitly as the driver of ECB monetary tightening, mentioning economic growth was superfluous. But we get the idea: as economic prospects weaken, so could de Cos’ willingness to go along with normalisation.

 

One would less expect to encounter this attitude among Governing Council hawks, but even Belgian National Bank Governor Pierre Wunsch on Wednesday seemed to indicate that his readiness to support rate hikes also hinged on how well the euro area macroeconomy stood up per se.

 

Hiking to 1.5% was a ‘no brainer’, absent a ‘deep recession’, and policymakers were in a ‘very difficult situation’, with the economy ‘slowing down and inflation continuing to surprise on the upside’, he said.

Presumably Wunsch would explain that he meant no more than that a severe recession would weaken inflationary pressures. Indeed, it may be a mistaken impression in his case that regardless of inflation, he would more easily countenance rate hikes under circumstances not exceeding a moderate downturn.

Bank of Estonia Governor Madis Müller may have been thinking of a possible growth slowdown when he explicitly acknowledged last Friday that coming ECB rate hikes – which he seemed to regard as a given - implied ‘slower economic growth due to more expensive lending and, unfortunately, uncreated and sometimes lost jobs,’ but argued that ‘the consequences of persistently too fast price increases would be even worse.’

Central bankers naturally don’t want to appear indifferent to the human cost of policies, a consideration that hasn’t diminished in importance during Lagarde’s tenure. Perhaps Austrian National Bank Governor Robert Holzmann merely had this in mind when he last weekend said that ‘[w]e hope that this will not be necessary.’

‘This’ referred to monetary authorities’ willingness to accept a recession as the price of hiking interest rates.

‘What is very important when inflation rates are already very high is that these inflation rates do not become entrenched in people's minds and inflation expectations do not get unanchored’, Holzmann said. ‘If the indications of this should strengthen, one would have to accept a slight recession, if necessary, in order to bring inflation down.’

With data steadily deteriorating – ‘everything was dismal’, Visco said of the latest economic indicators – it won’t be long before the ECB has to make uncomfortable choices that reveal the degree to which a possible recession matters in and of itself as opposed to mattering exclusively by virtue of its meaning for inflation.

Most likely or indeed inevitable is that where individual Council members stand will vary. That by itself could make it harder to achieve consensus and ultimately bring monetary policy normalisation – or at least its current phase - to an unexpectedly rapid conclusion.