The ECB should further tighten its course

In an op-ed first published in the Frankfurter Allgemeine Zeitung, Prof. Dr. Andreas Dombret, member of Atlantik-Brücke’s board and Global Senior Advisor at Oliver Wyman, stresses that ECB President Lagarde should not be dissuaded from her path of interest rates. In addition to this there should also be plans to reduce the ECB’s securities holdings. You can also read his guest contribution in the initial publication of the FAZ here.

The European Central Bank has been in permanent crisis mode for 15 years now. In 2008 the focus was on cushioning the shock waves of the global financial crisis and the associated recession. Shortly thereafter, the sovereign debt crisis hit the EU. Since neither the EU nor the member states were able to act in time for economic and structural reasons, the ECB has taken on the task of preventing the monetary union from falling apart. Covid also required decisive action and the ECB stood by fiscal policy with monetary policy.

As important as all these measures were, their consequences were just as extensive, above all in the form of a sharp expansion of the Eurosystem’s balance sheet and its dominant role as a buyer of public debt, which comes close to monetary public financing or – in another view – this red line has already exceeded.

For the ECB, whose central goal is price stability, the crisis of the hour is now inflation. It reached 10% with us in October and November. In Germany, this is the highest value since the currency reform of 1948 and includes enormous core inflation. Baltic states are even confronted with inflation rates of over 20%.

Central banks have underestimated the risk of inflation

The reasons are different. The most important one in the short term – the high energy prices as a result of the Russian war in Ukraine – lies outside the ECB’s sphere of influence and was not foreseeable by the central banks. However, it cannot be denied that the consequences of the expansive monetary policy of recent years and the extensive fiscal support packages have at least favored price developments. It also didn’t help that central banks around the world overestimated the risk of inflation for a decade, but initially stubbornly underestimated it until the summer of this year after the pandemic.

The Governing Council is aware of the risks to its own credibility. This year alone, the key euro interest rates were raised by 2% in several stages up to November. At the meeting on 15.12. a further rate hike is to be expected.

The fact that energy is an important driver of inflation outside the euro zone is significant, but ultimately irrelevant: the ECB’s price stability mandate not only relates to domestic economic factors, but also to the price level in general. A tightening of monetary policy has a cooling effect on the economy and thus also on inflation, which is not only driven by energy prices. Because in the last few months, significant price increases have also been observed in the service sector or for non-energy-intensive products.

Tightening too much could exacerbate a recession

Nevertheless, it is important to note that a reduction in growth has negative effects, not least on the labor market. But even in view of the determined intervention of monetary policy, these effects have so far been manageable. In the euro zone, we are currently not confronted with either interest-driven real estate crises or credit crunches. In addition, the labor market has dried up in large parts of the eurozone, while wage increases have been contained.

Looking to the future, it must be borne in mind that the economic outlook has deteriorated significantly in recent months, mainly due to the Russian war in Ukraine and increasing geopolitical tensions. With the necessary measures to combat climate change, the likely resulting higher energy prices in the long term, demographics and the costs of even a moderate reversal of globalization, Europe is confronted with developments that can have a lasting negative impact on economic growth. For Germany, the IMF expects a decline in economic output of 0.3% in 2023, one of the lowest values ​​​​in the euro zone. There is therefore a risk that the ECB and other central banks will tighten too much and thus exacerbate a recession unduly.

We’re not there yet. The neutral or balanced interest rate, at which monetary policy neither boosts nor slows down the economy and leads to the target inflation rate of 2% over time, has not yet been reached in a number of countries in the euro zone. Once again, the problem for the ECB is that it has to define a uniform monetary policy for the euro zone, while the individual countries have different prerequisites in terms of competitiveness, labor market and debt. The ECB’s policy will therefore be too restrictive for some countries and too loose for others. However, this is preferable to a situation in which an overly accommodative monetary policy leads to excessive price increases over a long period of time.

The ECB’s credibility is at stake

Of course, the risk of monetary policy overshooting should not be ignored. To make matters worse, monetary policy measures are only reflected in most key economic indicators after months. However, since the neutral interest rate has not yet been reached, I am firmly convinced that further tightening is indicated for the time being, especially since the current level of inflation is many times higher than the ECB’s target rate and has not yet fallen noticeably. For me, the question of slowing down the steps will only arise next year. It is to be hoped that the geopolitical and thus the economic situation can then also be assessed with somewhat greater certainty.

Finally, the international dimension must be taken into account. The Fed has consistently committed itself to fighting inflation, as has the Bank of England. Governor Jay Powell has said in no uncertain terms that he is willing to accept negative growth effects in order to combat inflation in the long term, especially since the US, where the Fed also has the mandate of full employment, has an overheated labor market.

I think it is absolutely right that the Governing Council of the ECB has committed itself so resolutely to combating inflation this year. I am firmly convinced that Germany must give the ECB full support on this course. To put it bluntly: the ECB Governing Council, led by Christine Lagarde, is on the right monetary policy path. However, one should not allow oneself to be dissuaded from this path and, in addition to further, well-considered interest rate increases, plans should be presented for the gradual reduction of the ECB’s securities holdings. Otherwise the credibility of the ECB and the euro as an international reserve currency would be at stake. And that’s the only way inflation expectations will remain anchored.