Inflation poses 19 problems for a single central bank

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SINTRA, Portugal — For central bankers, the world has changed abruptly. After more than a decade of low inflation and low interest rates, policymakers now find themselves in a high inflation environment, where there is no time for heavy-handed decisions, only quick and decisive.

That’s the verdict of policymakers and economists who gathered at a luxury golf resort northwest of Lisbon this week for the European Central Bank’s annual forum.

Since 2014, this annual Sintra meeting has been concerned with a major objective: how to fuel inflation in the euro zone.

Not this year. Amid widespread global supply chain disruptions, a war in Ukraine and soaring energy prices, policymakers face the opposite challenge. Inflation is the highest in decades. On Friday, data showed the annual rate of inflation in the euro zone jumped to 8.6% in June, a new record high.

But while the outlook for price growth involves many variables beyond the central bank’s control — such as the length of the war and the future of energy supplies from Russia and elsewhere — the message to officials of the central bank was clear: the responsibility lies with you.

Above the panel discussions and presentations hung memories of past crises, including the era of global stagflation of the 1970s and the euro sovereign debt crisis a decade ago. Like many other advanced economies, Europe is trying to avoid the trap of stagflation – a period of stagnant economic growth and excessively high inflation – but it is also trying to raise interest rates without spreading panic over government bond markets about the finances of the region’s most indebted countries.

“Monetary policy is at a difficult time,” Christine Lagarde, the ECB’s president, said as the forum opened on Monday, a statement no one in the room disagreed with.

Over the next two days, she reiterated the central bank’s plan to raise interest rates for the first time in more than a decade in July by a quarter of a percentage point, and again in September. with an increase that should be even greater. Rates should continue to rise from there, in accordance with a principle of “gradualism”.

The risk of persistently high inflation outweighed fears of a slowdown in the region’s economy. There may not be a return to the world of low inflation that has dominated the past few decades, Ms Lagarde said. Inflationary forces have been “unleashed” by the Covid-19 pandemic and the war in Ukraine, she added.

After a two-year hiatus from in-person meetings due to the pandemic, the collegiate The mood was palpable with the somber message of the seriousness of the challenge facing central bankers.

Despite the mounting mountains of economic, trade and financial data, figuring out where people think inflation is going is, to some extent, like reading tea leaves. A panel explained how difficult it is to know which inflation expectations are most useful for forecasting inflation – those of households, companies or financial markets. And how there was still no clear way of knowing whether long-term expectations had exceeded the central bank’s target, a dangerous situation that would perpetuate high inflation.

But policymakers can’t risk waiting to find out, Loretta J. Mester, president of the Federal Reserve Bank of Cleveland, told the audience. “Central banks are going to have to be resolute and they are going to be intentional in taking action to bring inflation down,” she added.

And those actions could be painful for people, warned Jerome H. Powell, the chairman of the Federal Reserve, a conclusion with which Ms. Lagarde agreed. But, he said, it would be more painful to let high inflation persist.

The ECB is just starting to raise interest rates, months after its US counterpart. High inflation is a global problem, but for a time the difference in the sources of price increases allowed the ECB to take a slower approach. High energy prices and global supply chain disruptions are not things the bank can stop by raising interest rates. Unlike the Fed, European policymakers are not looking to cool an overheated economy. In Europe, consumption has not even returned to pre-pandemic levels.

As inflation soared and the bank’s own economists began issuing harsher forecasts, the risk grew that rapid price growth would take hold. After a few months of division on the board, as a handful of pricing executives pushed for faster action, a sense of unanimity is slowly emerging.

“Looking back, I think many members of the board of governors would have liked to raise rates as early as June,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “But it’s a very difficult situation because you know we’re heading for a downturn.”

However, for now, “inflation concerns trump everything else,” he added.

What differentiates today from the 1970s is that central bankers can act more aggressively and are more active, said Hilde C. Bjornland, professor of economics at BI Norwegian Business School, in a presentation by the recent increase in oil prices and how this is weighing on the European economy and affecting inflation expectations.

“It needs quick action from the central bank, and it needs that quick action now,” she said.

What has not changed for the central bank since its inception is that it still holds together a monetary union – the eurozone – without the supporting infrastructure of a fiscal, banking or union capital markets.

It must provide a policy for 19 savings. In June, inflation ranged from 6.1% in Malta to 22% in Estonia.

“This is one of the problems that the euro zone and the European Union must tackle,” said Martins Kazaks, governor of the central bank of Latvia, where inflation has reached 19%. “The institutional architecture of the euro area and the European Union is far from complete.” Fiscal policy must step in and provide support to the most vulnerable, but it must be targeted and time-bound, unlike pandemic support programs, he added.

“In the current situation, when inflation is so high, monetary policy will have to tackle the problem of inflation,” he said. “We will not go in the same direction as fiscal policy.” He suggested that the rate increase in July may need to be larger than the currently telegraphed quarter point. Gradualism “does not mean slow,” Kazaks said.

As the ECB battles this inflation problem, it must stave off another crisis – the risk that rising interest rates and the end of massive bond-buying programs will send borrowing costs skyrocketing. financially weaker savings. In mid-June, Italy’s 10-year government debt yield jumped above 4% for the first time since 2014, and the spread over Germany’s borrowing costs, the benchmark for the region, was the widest since the start of 2020, when the pandemic rocked financial markets.

In response to growing disparities in borrowing costs, the central bank announced that it would use reinvestments of maturing bonds in its €1.85 trillion pandemic-era bond purchase program ( $1.9 trillion) to buy more bonds to help stave off so-called market fragmentation that could disrupt the effectiveness of its monetary policy. The bank also said it would accelerate the design of a new policy tool to address this issue, according to Ms Lagarde.

Any new tool should be mindful of the legal and policy challenges it may face. Ten years ago, the central bank attempted to devise a policy tool that would match former central bank president Mario Draghi’s pledge to do ‘whatever it takes’ to save the euro .

The result of this effort was a program allowing the central bank to buy in the market an unlimited amount of debt issued by countries in difficulty provided that they were part of a formal rescue program, where a separate body implemented economic reforms. The initiative was met with legal challenges and political fights – but, in the end, the announcement of this tool was enough to calm investors in the bond market.

It has never been used.

Volatility in the bond market is now less severe, so the new tool should not come with such stringent conditions. But the bank will have to carefully design a tool to avoid sending a confusing message of monetary policy tightening on the one hand but monetary policy easing on the other.

But this challenge will not stand in the way of what Ms. Lagarde now presents as a lucid vision focused on the fight against inflation.

“We will address any obstacles that could pose a threat to our price stability mandate,” she said. “We will do it.”

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