Following a series of abrupt interest rate hikes by the US Federal Reserve and the European Central Bank, headline inflation is rapidly declining in the US and the eurozone. But monetary authorities have made it obvious that they are not finished yet on both sides of the Atlantic. Will they overstep their bounds?
Core inflation, which is still hovering around 5% in the US and the eurozone, is a significant cause for concern. Given a strong labor market, central banks worry that high core inflation (which excludes food and energy prices) runs the danger of escalating wage-price spirals and de-anchoring inflation expectations. This could make controlling inflation extremely difficult, expensive, and provide a problem for central banks in restoring lost confidence, as we discovered in the 1970s.
Given this, officials appear to have come to the conclusion that it is better to err on the side of excessive tightening since the consequences of doing too little to tighten monetary conditions are simply too great. This opinion has been stated quite plainly by the ECB. However, the ECB must not undervalue the consequences that being incorrect poses to both the eurozone economy and its own reputation. And it might even be incorrect.
The early 2022 inflation spike in the eurozone was mostly caused by supply shocks, which resulted in significant relative price increases. The energy shock in Europe was greater than in the US, and the fiscal response was less severe. Additionally, the EU has seen a negative terms-of-trade shock due to its net energy importation, which has decreased real disposable income.
However, the supply interruptions that led to price increases have already subsided, and monetary tightening is beginning to take hold. Yes, core inflation is still high. However, this is expected, as my co-authors Veronica Guerrieri, Michala Marcussen, and Silvana Tenreyro and I demonstrate in a new research, because of the process by which prices across sectors adapt.
Energy shocks and supply-chain disruptions have varying degrees of impact on different sectors, which causes a reallocation of resources across sectors that is accomplished through relative price changes. However, the costs of goods and services are persistent, and the input-output relationships connecting various economic activity are intricate. As a result, not all industries will see disinflation right now. Prices typically rise with a lag and inflation declines gradually, especially in the services sector, which is only indirectly impacted by increasing energy prices.
Given this, one may anticipate core inflation to remain high until it declines for a while. However, there is little justification for trying to speed up that timescale. Aggressive actions to lower average inflation, on the other hand, would sabotage the adjustment process and lead to inefficiency. We already know that severe monetary tightening reduces demand, but it would also reduce consumption by impairing efficiency since it would disrupt resource reallocation.
The last thing Europe needs is this. Industrial production drastically declined in the second quarter of this year, and indicators of credit conditions have been particularly poor. In contrast to the US, consumption and investment in the EU are still behind the trend predicted for 2019. Concerns about the consequences of increased pressure, let alone a new recession, have been raised by many people, including central bankers, particularly in Italy and Portugal.
The ECB has one major goal, as opposed to the Fed, which has two mandates: price stability, which is defined at 2% inflation over an unspecified “medium term.” This could be the reason for the ECB’s bias toward tightening when evaluating the risks in the balance. Even if the ECB is required by treaty to serve the EU’s more general economic goals, having a main mission does not mean that nothing else is important.
Therefore, while the ECB is developing a policy to achieve price stability, it should also take into account secondary costs that may impair the EU’s capacity to achieve other goals in areas like consumption, employment, and financial stability. In fact, the duration of the “medium term” should be influenced by those costs. The greater the time horizon for ensuring price stability, the higher the costs.
However, the ECB appears to have a stricter understanding of its mandate for price stability. It has advocated for stricter fiscal policy to help its fight against inflation rather than altering its strategy to support other goals. The events of 2011—when oil-driven inflation and deteriorating real economic circumstances prompted the ECB to conduct two interest rate hikes and call for budgetary restraint—appear to have taught policymakers nothing. As a result, there was a recession that, when combined with the banking and government debt problems, stoked broad anti-EU sentiment.
The huge budgetary support put in place during the epidemic may have contributed to the American economy’s apparent greater resilience than that of Europe. In fact, it is more likely than ever before that the US will experience a gentle landing, returning inflation to the Fed’s objective without starting a recession. Europe could not be as fortunate unless the ECB adopts a more patient approach to its price-stability mandate.