ECB: Could Need Tighter Monetary Policy if Govt Measures Not Targeted, Temporary and Tailored

13 February 2023

By David Barwick – FRANKFURT (Econostream) – Government fiscal measures to offset the blow from high inflation should be targeted, temporary and not distort market signals, lest monetary policy need additional tightening, the European Central Bank said on Monday.

In a pre-release from the first economic bulletin of 2023, due out Thursday, the ECB said that the current high inflation could cause the fiscal positions of euro area member countries to deteriorate beyond the near term even without taking into account special measures to mitigate the impact on consumers of price rises.

‘This negative impact can primarily be explained by the nature and size of the inflation shock in the euro area –mainly a large, external energy shock that generates less tax revenues in relation to its size, negatively affects firms’ profitability and growth and puts high pressure on nominal public spending’, the ECB said.

At the same time, monetary tightening to ward off second-round effects from the inflation shock also means governments must pay higher interest on sovereign debt, the ECB noted.

‘In terms of the euro area debt-to-GDP ratio, the analysis shows that, beyond the short run and conditional on the monetary policy reaction, a negative impact on economic activity from an adverse supply shock may outweigh the positive impact of higher inflation on debt ratios’, the ECB said.

Whilst ‘significant’, the redistributive and macroeconomic effects of government measures in response to high inflation are transient, according to the ECB, and include reduced price pressures in 2022-2023 that then give way to increased inflation in 2024-2025, though the extent of the impact either way is uncertain.

The government measures also boost GDP growth and nominal disposable income at the outset, the ECB reported.

‘However, despite being progressive, some fiscal measures are not very efficient from an economic perspective’, it said. ‘Only a relatively small share of the support is estimated to target lower-income households.’

In addition, the increased fiscal burden ‘may pose additional challenges in an environment of rising interest payments, particularly in highly indebted countries’, the ECB said.

Overall, to avoid contributing to inflation pressures, government measures should be temporary, targeted and not distort price signals that would disincentivise energy consumption; otherwise, they might ‘necessitate a stronger monetary policy response’, the ECB warned.

‘Fiscal policies should therefore be oriented towards making the euro area economy more productive, rebuilding fiscal buffers and gradually bringing down high levels of public debt’, it added.