“Shocked, shocked” about the ECB’s commitment to price stability
We are somewhat astounded by commentators who purport to be “shocked, shocked” that the ECB is pursuing a price stability target after all. You can’t blame those central bankers for not telling you. How often have they annoyed us with long and boring speeches preaching the virtues of price stability. And when they actually do what they say, we are totally surprised.
But this is no rocket science. The ECB’s recent rate increase was clearly intended to stabilise inflationary expectations, and to signal to wage setters that the ECB is determined to go against the consensus if need be.
Some analysts badly got the ECB wrong in their forecast, and they are now blaming the central bank for their own error. They made the mistake to extrapolate historic trends into the future, by assuming that the ECB, despite all the rhetoric, was operating a de facto dual target. Even if you can fit a Taylor rule to the ECB’s past behaviour, which you can, you cannot extrapolate because there had been no such conflicts between growth and inflation as there have been now. This is a regime change that tests the central bank’s own regime.
We suspect that investors would be losing serious money if they believed that the ECB followed a growth goal – as some analysts seem to suggest – or some mixed goal. The simple answer to the question, how dare the ECB raise interest rates if there is evidence of a serious economic downturn is this: if economic weakness is the only to get price stability, the ECB will choose it. This is not America. Pure recession-avoidance is a dumb and unsustainable strategy, as we are currently about to find out.
So what about inflation? The latest published ECB staff forecast points towards a range which is clearly above the target – the lower end of the range is right on target, and the upper end is close to 3%, with the average of about 2.5% for next year. So if you take the ECB euro area wide model as your medium-term forecasting model of the European economy, you would clearly continue to raise rates, as Wicksell has suggested, until the forecast meets the target again. If you followed this action, the ECB would not stop at 4.25%, but continue to raise rates several times more this year. If the ECB is not going down this road, then clearly it is due to the uncertainty about the economic development. The likely economic downturn is the reason why interest rates are not a 5% or higher.
And finally: Is a recession likely? Quite possibly but not certainly. We trust the ECB forecast a little more than the private-sector projections, but we also think they may a touch too optimistic. We never believed in the tale peddled by the Bundesbank and others earlier this year that Germany in particular was immune to global trends, on the grounds that its exports were price-inelastic. This is simply not true – at least not when the euro’s exchange rate has shot up so much. Germany has had a lousy second quarter, perhaps with negative growth, and the outlook for the third quarter is not great either. Italy is stagnating, France is weakening, Spain is falling off the cliff. So yes, this is a weakening economic environment. The Europeans face the same uneasy choices as the Brits, where the Bank of England stoically maintains its interest rate at 5%, despite evidence of a horrific house price crash.
We would expect inflation to continue to overshoot for a while, and to exceed analysts’ expectations. A good rule of thumb is that the ECB does not like the “real interest rate for dummies” – i.e. nominal rates minus current inflation to become negative by more than a trivial amount. This is the reason did not go below 2% during the previous downturn – as this was precisely the inflation target. So if inflation peaks at 4.2%, this was the last rate increase. But if it goes up to 4.5%, we would not rule out another rate rise. So the interesting question is not whether the ECB will raise again or not – the ECB does not know that either – but whether inflation is going to 4.5% or not.