By David Barwick – FRANKFURT (Econostream) – European Central Bank Executive Board member Isabel Schnabel warned Thursday that large and persistent supply shocks could require a timely monetary policy response, saying consumer inflation expectations had moved away from the ECB's target following the latest energy shock.
“In response to the latest energy shock, consumer inflation expectations over the medium to longer term have increased and gradually moved away from our 2% target,” Schnabel said in a speech prepared for the ECB Conference on Money Markets.
Schnabel argued that the traditional distinction between demand shocks, which generally call for an immediate monetary policy response, and supply shocks, which central banks can often look through, could be misleading.
A sufficiently large and persistent adverse supply shock could push projected inflation above target, necessitating timely action, she said.
“What matters is how shocks affect the inflation outlook,” Schnabel said.
The ECB was again confronting overlapping shocks, including geopolitical tensions, higher energy prices, rapidly expanding investment related to artificial intelligence and substantial fiscal spending requirements, particularly for defense.
Such developments affected demand, productive capacity, prices and financial conditions through different channels and over different time horizons, Schnabel said.
She warned that adverse supply shocks were likely to become more frequent and persistent owing to geopolitical fragmentation and climate change, increasing the importance of assessing their effects on inflation expectations, wages and price-setting behavior.
Schnabel said the ECB had drawn lessons from its delayed response to the post-pandemic inflation surge, when policymakers initially failed to recognize that the economy had moved from an environment of persistently low inflation to one characterized by recurring inflationary shocks.
In responding to the latest energy shock, ECB staff had rapidly developed scenarios incorporating different assumptions about indirect and second-round effects, enabling monetary policy to react to the expected persistence of inflation pressures in a timely and forward-looking manner, she said.
“As a result, we are now well positioned to address the current inflation challenge,” Schnabel said.
Reflecting on her nearly seven years at the ECB as she approached the end of her term, Schnabel also argued that central banks should preserve flexibility by avoiding commitments that could become inappropriate when economic circumstances changed.
“In retrospect, forward guidance during the pandemic was too Odyssean,” she said, arguing that it had tied policymakers too closely to assumptions of persistently low inflation.
Interest rates were inherently more flexible than large-scale asset purchases, which continued to provide monetary accommodation long after purchases had ended, Schnabel said.
That was an important reason for emphasizing policy rates as the ECB's primary monetary policy instrument, although asset purchases remained useful for addressing deflationary pressures at the effective lower bound and stabilizing dysfunctional financial markets.
Schnabel pointed to the ECB's Transmission Protection Instrument as an example of separating instruments used to stabilize markets from those used to calibrate the monetary policy stance.
She also warned that rising public debt and the growing importance of non-bank financial intermediaries could increasingly threaten central banks' ability to pursue price stability independently of financial and fiscal considerations.
As central banks reduced their bond holdings, governments were becoming more dependent on price-sensitive private investors, including leveraged hedge funds, Schnabel said.
In periods of heightened volatility, forced liquidations by such investors could destabilize sovereign bond markets and require central bank intervention to prevent broader financial crises, she said.
Such interventions could interfere with monetary policy and threaten monetary dominance, she said.
Schnabel called for stronger regulation of non-bank financial institutions and warned against weakening banking regulations introduced following the global financial crisis.
“Many of the arguments put forward in favor of deregulation are flawed. Its benefits are doubtful and its potential costs are significant,” she said.
She also emphasized the need for prudent fiscal policies, noting that the differential between government borrowing costs and economic growth had turned positive in many countries and was likely to increase as governments refinanced maturing debt at higher interest rates.
Turning to the implementation of monetary policy, Schnabel argued that central banks should operate with balance sheets no larger than necessary, citing the financial risks, market distortions and increased dependence on central bank liquidity associated with abundant reserves.
She said the ECB was continuing to reduce its asset purchase programme and pandemic emergency purchase programme portfolios because the monetary policy justification for maintaining them no longer existed.
“In principle, we can reduce them all the way to zero, unless we were to return to the effective lower bound, in which case renewed purchases might become necessary to protect price stability,” Schnabel said.
As excess liquidity declined, banks would increasingly rely on standard ECB refinancing operations, allowing the central bank to assess their underlying demand for reserves, she said.
Once persistent liquidity needs became apparent, the ECB could provide longer-term structural funding rather than requiring banks to refinance large amounts every week, she said.
Schnabel said the natural sequence would be to introduce structural longer-term refinancing operations first, because the existing asset purchase portfolios would continue supplying liquidity for an extended period.
A structural securities portfolio would then be built gradually once the legacy holdings had declined sufficiently, she said.
The fundamental principle would be that marginal liquidity was supplied in response to banks' demand rather than at the central bank's initiative, Schnabel said.