Fighting inflation in times of crisis
Amid banking turmoil and worries about further turbulences, central bankers, market participants, and academics gathered at the 23rd edition of The ECB and Its Watchers on March 22, 2023. At the conference, organized by Prof. Volker Wieland, ECB policymakers made it clear that the European Central Bank will watch for signs of stress in bank lending from the ongoing financial turmoil but remains focused on its primary objective. "Bringing inflation back to 2% over the medium term is non-negotiable," ECB President Christine Lagarde told the audience. "For inflationary pressures to ease, it is important that our monetary policy works robustly in the restrictive direction," she said. "And that process is only starting to take effect now." There is no trade-off between price stability and financial stability, she added.
Lagarde’s opening speech at The ECB and Its Watchers XXIII followed only a week after the central bank’s decision to raise its key rates by a further 50 basis points with the interest rate on main financing operations (MRO) reaching 3.5%. Inflation in the euro area still marked 8.5% a month ago. Besides, further worries emerged due to the collapse of Silicon Valley Bank and Signature Bank in the US and the fallout from Switzerland‘s Credit Suisse takeover.
Philip Lane, ECB chief economist, showed himself convinced that there is no imminent banking crisis. He said turbulences on the financial markets may turn out to be a "non-event" for monetary policy or could affect it at the margins. According to Lane, underlying inflation in the euro area will fall along with energy prices but the continued easing of consumer inflation is predicated on wage growth peaking in 2023. In her contribution to the debate on how to get inflation back to target, Monika Merz of the University of Vienna emphasized that credible, unambiguous central bank communication of being committed to the inflation target accompanied by continued quantitative tightening is essential. "High inflation rates impose an inflation tax on all of us. It’s making life really expensive," she said. With regard to labor market issues, Merz pointed out that disciplining inflationary expectations was key to controlling inflation, e.g. to avoid kicking off a wage-price spiral.
In his presentation, Michael Bordo of Rutgers University put the recent inflation experience in historical context. "Fed tightening is frequently followed by financial instability," Bordo warned, providing lessons from the past. "Rising rates always reveals underlying imbalances." To overcome the current dilemma of reducing high inflation and maintaining financial stability, Bordo referred to Tinbergen’s principle: Use lender of last resort tools for financial stability and monetary policy for price stability. According to Bordo, the ECB followed this principle. However, he wasn’t convinced the Fed would maintain "its anti-inflation resolve if its tightening generates financial instability and recession."
During the second debate on fiscal effects on inflation and inflationary effects of fiscal policy, Pierre Wunsch, Governor of the National Bank of Belgium, noted that fiscal policy in Europe was too procyclical during upturns. "The low for too long of interest rates before the covid crisis have contributed to create a culture of easy money," he said. "The euro area has been flirting with some kind of weak form of fiscal dominance for more than ten years now. I believe it's time to go back to the Maastricht Treaty." According to Luisa Lambertini of the Ecole Polytechnique Fédérale de Lausanne, fiscal policy always has inflationary effects. However, the long-term risk of higher borrowing cost could create a snowball effect in the debt to GDP ratio. Regarding the current economic conditions, Lambertini warned that "being vigilant and flexible in accompanying the process of fiscal consolidation is absolutely fundamental."
In his contribution, Thiess Büttner, University of Erlangen-Nürnberg, focused on the European fiscal rules, coming to the conclusion that the European Commission’s "whatever it takes" attitude during the pandemic has compromised fiscal rules. A quick return to the rule-based fiscal policy would have reduced inflationary pressure. "When most needed the fiscal rules are now in limbo," Büttner said.
With regard to how to coordinate policies in a world of global shocks and geostrategic risks, ECB Board Member Fabio Panetta stressed the need "to adapt our policies due to the overlapping effects of the shocks." He recommended three principles to help guide monetary policy decisions: "to remain fully data-dependent and avoid pre-committing," "to continuously assess the combined effect of raising rates and reducing the size of our balance sheet," and to consider how the shocks are "transmitted across markets and economies as well as the potential spillovers from policies adopted abroad."
In the view of Nouriel Roubini of New York University the era of Great Moderation, low inflation and reasonably stable growth is over. "We are entering a new era, a regime change of great stagflationary and debt instability," he argued, pointing to further threats such as climate change, deglobalization, and the current geopolitical situation. With respect to current challenges such as energy security, green transition and geostrategic problems, Willem Buiter of the Council of Foreign Relations concluded that central banks should be "fully aware of the implications for their financial stability and price stability or dual mandates." However, central banks should only target mitigation of the wider economic and social damage caused by those challenges. "The instruments at their disposal should be devoted fully to the tasks of price stability and financial stability."