25th Sep 2023


Central banks can't fight inflation alone — their tools are too blunt

  • Philipp Heimberger: 'I think there is something wrong with prevalent monetary policy ideas when central banks protect their credibility by pushing economies deeper into recession' (Photo: Philipp Heimberger)
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To drive down inflation, central banks around the world have increased interest rates on an unprecedented scale.

By increasing the cost of borrowing, the banks are trying to raise unemployment and lower wage growth, which will further lower demand to a level equal to supply, especially for gas. In other words, make people poorer on average so they can spend less.

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  • Annual inflation in the Eurozone was 10 percent in September 2022, up from 9.1 percent in August, according to Eurostat. (Photo: Bernard Hermant)

But as the world moves towards global recession, warnings about monetary overkill are growing louder.

To better understand the risks involved with higher interest rates, EUobserver spoke to Philipp Heimberger, an Austrian economist at the Vienna Institute for International Economic Studies and prolific commentator who has consistently questioned the reasoning behind the wave of historic rate rises.

"We have built a system where central banks like the ECB are pressured to overreact with interest rate hikes," he told EUobserver. "I think there is something wrong with prevalent monetary policy ideas when central banks protect their credibility by pushing economies deeper into recession."

EUobserver: Are central banks making a mistake? Inflation in Europe has reached a multi-decade high of 10 percent, so understandably people want someone to do something about it.

Philipp Heimberger: "Inflation in the euro area is not due to an overheating economy. It is driven by high energy prices and the disruption of supply chains which the ECB itself has said it cannot directly influence.

It's clear the ECB's management is in a tough spot. They're under extreme pressure from monetary hawks, as many of them still believe in monetarist views when responding aggressively to inflation.

But I think a hawkish stance now is fundamentally flawed, and a careful stepwise process is much more warranted. And there are good arguments why the ECB should stay put or at least not hike interest rates aggressively because the idea to do so rests on very shaky grounds, but unfortunately, the mainstream doesn't challenge these justifications."

Why? What are the shaky foundations?

There are a few. The idea of neutral interest rate where the economy is neither overheated nor stuck and inflation at 'target', for example. This is a very fraught and problematic concept.

Any economist who has critically engaged with this knows that there are good reasons to believe that something like a natural interest rate reflecting fundamental economic forces does not exist.

Even if it were to exist, the estimation uncertainty around where this natural rate would supposedly be is huge, making it a useless guide for policy making.

What other justifications for aggressive rate hiking does the ECB give?

The most important one is the alleged danger of so-called inflation expectations becoming de-anchored. This is the belief that household and business expectations of future inflation are a key driver of actual inflation down the road. It's a core pillar of modern central banking theory and practice.

What's the problem with it?

When you thoroughly review the relevant theoretical and empirical literature on inflation expectations, you find that they are very changeable. People change their expectations. They adapted to recent increases in energy prices, but then they may also relatively abruptly adapt to falling energy prices next year. You have to question how informative measures of inflation expectations of households and firms actually are.

Taking monetary policy decisions in an environment of severe uncertainty based on these expectations data could easily lead to serious policy errors. Interest rates are a very blunt tool and can cause severe collateral damage. I think they should be much more cautious.

Wage-price spiral

Christine Lagarde, in a September lecture, explained that if "expectations become de-anchored and trigger a wage-price spiral, it can lead to inflation becoming persistent" even after the energy shock disappears. Should we not be mindful of this?

Yes, but the thing is, we're not seeing a wage-price spiral. We need to be clear about that. What we're seeing are massive real wage losses. According to ECB figures, inflation-adjusted wage loss for workers in the euro area was about five percent in real terms. Next year the ECB also does not see a major acceleration of wage growth, which is very unlikely anyway, as the economy is moving into recession. Trade unions don't have strong wage bargaining positions in such an environment.

The US Federal Reserve has acted much more aggressively. Some blame the ECB for not raising rates sooner. The euro has lost 15 percent of its value this year, pushing up the relative price of oil, which is denominated in dollars. By raising rates, the ECB is trying to strengthen the euro. Are they wrong to do this?

We need to recognise that the energy crisis is an adverse shock to Europe's industrial sector and manufacturing base. In a situation where the US is not nearly as hard hit as the EU, a falling euro is, to some extent, what you would expect. Increasing interest rates while the economy is deteriorating could even have the opposite effect of what is intended.

How so?

Bond market investors could perceive it as a policy mistake as it would further slow down the EU economy. They could even speculate against the euro [by selling off euro-denominated assets], which would drive down the euro further. So if you want to support the euro, arguably the best approach is to be cautious and not to hike interest rates.

There is a historical element to this. In the 1970s and 80s, inflation was also high, and interest rates were even higher. This succeeded in bringing down inflation but also caused a severe recession and debt crisis around the globe. Current Fed chair Jerome Powell is leading other central banks in rate hikes, frequently invokes this period to explain his own decisions. Is he right to do so?

I think comparisons with the 1970s are way off. The institutional context and the economic context are very different now. Trade union density is much lower than in the 1970s, and there is now a high level of economic globalisation, which also makes it more difficult to negotiate higher wages.

So I mean, it's clear that the ECB needs to track wages closely. Actually, it would be good to have better data quality in real-time on this.

But we are not seeing any indications of a wage-price spiral. So I think it's particularly problematic to base monetary policy decisions on something very unlikely to materialise.

Lagarde warned against raising rates until the summer. This quite abruptly switched. What happened?

Their credibility is under threat. The ECB has been under intense pressure from monetary hawks in Germany and other countries to respond more aggressively to rising inflation rates.

Inflation started to rise last year when the economy reopened. First, the ECB, and I think rightly so, wanted to wait and see how this temporary post-covid inflation would develop, which was mainly driven by broken supply chains and reopening after lockdowns.

But then Ukraine was invaded, and the energy supply was disrupted, which further boosted inflation via supply-side disruptions. With inflation now well above the target of two per cent, the ECB is under intense pressure to protect itself from political attacks.

But the consequences are severe. Aggressive rate hikes push down wages and ultimately cause unemployment to rise. And that could affect millions of workers in the euro area.

Is there an alternative?

We need to coordinate across different policy areas to take the pressure off the ECB and reduce the risk of a monetary policy overreaction in terms of interest rate hikes.

ECB vice president Luis de Guindos, from Spain, also recently pointed out that national governments must use their budget policies to support monetary policy and fight inflation.

So, for example, targeted support measures can help mitigate the hardship of price increases for the most vulnerable households and businesses. Targeted measures to reduce energy price increases, preferably coordinated at the European level, can also reduce pressure on wage negotiators at the national level.

After all, if the energy price burden falls, this also implies that nominal wage settlements can be somewhat lower. And this also then reduces the costs to businesses and takes away these second-round effects.

What is stopping this?

We still live under the illusion that the central bank is this almighty institution that can take care of price stability independently of what other policymakers in governments do.

We have built a system where independent central banks like the ECB are pressured to overreact. They are responsible for price stability and are now firmly committed to basically doing whatever it takes to bring down inflation, even if it severely damages the economy.

But the ECB also has a secondary mandate, which says it should support general economic policies.

Why is the second mandate so important?

Energy prices are the key driver of inflation. So to ensure price stability in the medium and long run, governments must invest in a better, more stable energy system. And there, the ECB also plays a role.

Strong energy and climate investment require favourable financing conditions because climate investments are susceptible to higher borrowing costs as they require very large, upfront investments. Higher interest could lead to the cancellation of these projects.

That is something typically not mentioned by those who are in favour of aggressive rate hikes. But it is part of the job of the ECB to ensure climate and energy targets are met, which are part of the economic policy of the EU.

Will more investment in clean energy not push inflation further upwards?

Investment can also increase productive capacity. So more investments do not have to be inflationary. If you, for example, invest in transport infrastructure or critical areas of energy infrastructure, this will ensure lower inflation going forward.

Things are much more tricky than the monetary policy hawks would like them to be.

The public will eventually learn that the bank is relatively powerless to address supply-shock inflation because it is driven by energy and supply chain problems. So I think we need a much more nuanced democratic debate about this, and be very critical about the idea that further aggressive rate hikes are smart policy.

Financial stability

When the ECB raised interest rates at the cusp of a recession in 2010, it caused the EU sovereign debt crisis. The European Systemic Risk Board (ESRB) recently issued its first "general warning" for financial stability since its creation in 2010. Will the current moment lead to a repeat of past mistakes, or is there enough institutional memory and experience to prevent it?

It could well be that something breaks in the global financial system, which would also negatively affect the Euro area. So there are definitely similarities, but also differences. The ECB is in a somewhat different spot.

When it comes to backstopping bond markets, it has more credibility now than it had in 2010 or 2011. We also have the TPI, this new bond purchasing program, which I think was a good invention. But it is not yet clear when and whether the ECB will be able to use that at the proper scale.

And the global context is different from the early 2010s because we now see a global tightening cycle and severe rate hikes in low-income countries. If you look at recent economic forecasts, they suggest that we are heading towards a global recession. It is a threat to financial stability and a major problem for highly leveraged financial markets like the housing market.

You have raised the coordination issue between monetary and fiscal authorities. You have argued that the ECB should support government efforts in dealing with the energy crisis, not hamper it by raising interest rates. Concretely: what could this coordination look like?

We have a blueprint with the [€800bn] European pandemic recovery fund. Money flows to member states who have to spend it on digital innovation and climate investments, among other things. A great case is to be made that such an instrument should be permanent.

It would be seen as a statement of solidarity if European leaders could agree on European borrowing. It means investors could buy European safe assets. There would be fewer concerns for speculation against individual member countries, implying lower interest rate burdens for many member countries, if not for all of them. So if you look at it from the European perspective, it would also enhance stability.

How big does this fund need to be?

Conservatively speaking: what is needed to meet emission reduction targets, but also to meet the energy targets. So a fund of at least 1 percent of European GDP per year. Because I think it's clear that not every member state will be able to raise the additional money required to meet these targets. And given the fact that many of the problems we face are a common threat, it is essential all countries can actually deal with them.


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