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05 June 2021

Should we worry about inflation?

If economists are forecasting that inflation won’t rise, how should we interpret this? If they are wrong, will they say: ok, I made a mistake, or will they say instead that the rise in inflation will only be temporary? If that turns out to be wrong, will they say: got it wrong again, or rather: let’s overshoot for a while because we had such a long time of very low inflation? And if the overshoot turns out to be persistent, will they say: dammit, got it wrong again, or rather: better 10% inflation then 10% unemployment? I don’t think we have to stretch our minds to know where this will go. Those who are absolutely certain that inflation won’t rise are mostly the same people who couldn’t care less if it does.

I am not predicting that inflation will rise - or that it won’t. I just don’t know. I can see that inflation may rise in the US, and that this could affect the euro area indirectly. One scenario is for a rise in the price level in non-euro global supply chains, but without a compensating rise in the euro’s real trade-weighted exchange rate.

It is also possible that counter-acting deflationary forces might neutralise or overcompensate. There exists no single indicator that tells us what will happen. When monetary aggregates, like the infamous M3, increase over longer periods, that may mean something. Or it may mean nothing. It depends on whether the money gets sucked into the financial sector or ends up pushing up consumer prices. One back-of-the-envelope calculation is to compare the size of the US stimulus and of the US output gap and conclude that the stimulus is too high. But then again, the output gap is a very problematic indicator, as we learned in the euro area during the sovereign debt crisis. I am keeping an open mind.

So, should we be worried? The answer is: absolutely not. But we should be prepared. For the ECB, it means having a strategy in place and communicating it early. There is scope for a real communication accident down the road. If the ECB’s governing council blindly follows the Federal Reserve into the promised land of average inflation targeting, I would not be surprised to see a permanent decoupling from the 2% target. Reasonable people can disagree on what constitutes a good definition of price stability. I have listed a number of alternative targets and policies in our info-graphic above. The ECB is currently undertaking a seemingly never-ending monetary policy review, during which it will choose a replacement for the current target.

The first task is to choose a target. This is not just a numbers game. Inflation targets have not worked well in the last 10 years. There is a question to be asked whether direct inflation targeting is an appropriate monetary policy strategy. I will address this specific issue in a separate column. After the target is chosen, the next step is to define a strategy of the policy actions needed to cope with foreseeable situations, including an overshooting inflation rate. The ECB uses a whole array of non-conventional monetary policy instruments right now: the pandemic emergence purchasing programme, the ordinary, and still ongoing, asset purchase programmes, the zero interest rate policy with its highly calibrated rules, targeted longer-term refinancing operations to induce banks to lend to the private sector. Think of it as a Ferrari at top speed approaching a construction site on a motorway. Taking the foot off the pedal may not be enough to reduce the speed in time.

If an inflationary overshoot were to happen, the ECB would need to end the PEPP, possibly abruptly. It may have to start tapering the ASP too, by which I mean a gradual reduction in the stock of the assets, not just of net purchases. The way to achieve this is by not replacing bonds after redemption.

The zero interest rate policy would be next in line. I assume the ECB would start rolling back non-conventional policies like asset purchases first, and only then start raising interest rates. But the two could be done in parallel. In any case, it would be good to drop the communication strategy of forward guidance. It served the ECB well during the sovereign debt crisis because it helped shift expectations in one direction. In normal situations where central bankers do not know the direction of future policy, it is essential that they don’t bind their hands. Forward guidance is a 300km/h Ferrari on auto-pilot.

Is this what I expect will happen? No, it is not. I think they will try to muddle through. The worst case scenario is this: adjustment would be too slow, inflation overshoots. Monetary policy would then become what is known as fiscal dominance - a situation where the fiscal stance of the euro area's governments reduces the scope of monetary policy decisions.

If we are lucky, there won’t be any inflation, or it will only be temporary blip. But if inflation were to rise persistently, and if the ECB has no firm strategy in place, we will be in that worst-case scenario.

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