Walking a tight rope

It is definitely not an easy time to be a central banker

On one hand, whilst headline inflation has shown some declines, underlying inflation (excluding energy and food) has remained persistent and uncomfortably above central bank targets. This will likely remain so even by the end of 2024. Recent declines in energy prices, if they keep on the trajectory seen recently, should feed into lower underlying inflation, but not enough to bring it down quickly. As already hinted, this assumes that there will not be major bouts of financial stress i.e. no further escalation of Russia’s war in Ukraine and associated sanctions, keeping energy prices in check. Obviously if this is not so, things could get worse on all fronts with economic growth, inflation and financial stability risks, all complicating monetary, fiscal and regulatory policy choices.

On the other hand, another concern for central bankers like the ECB, is not pushing European economies into a deep recession. The latest data just published on the 28th April, indicates that in the first quarter of 2023, seasonally adjusted

GDP increased by 0.1% in the euro area and by 0.3% in the EU, compared with the previous quarter, according to a preliminary flash estimate published by Eurostat. As seen below the trajectory seems to indicate that a mixture of inflation and increased interest rates are having their toll on the economic growth momentum in Europe.

Faced with such uncertainty and such a tight rope, the ECB will likely maintain its path on a tight monetary policy until core inflation is unambiguously on a downward path back to the ECB’s inflation targets. It is very likely that as inflation is showing to be a sticky one, that the ECB will give more weight to the risks linked to underestimating the persistence of the current inflation, thus entrenching high inflation expectations and then forcing it to tighten later for longer, which would inevitably lead to a sharp economic recession – something the ECB is trying to avoid.

However, monetary policy on its own cannot succeed to walk this tight rope of winning this inflation monster and at the same avoid pushing European economies into a deep recession. There are other elements that will need a special focus.

The first element is fiscal policy. European governments need to to pursue more ambitious fiscal measures. We cannot have a situation where interest rates are rising to dampen demand and on the other hand fiscal policy keeps using wide ranging subsidies or energy relief measures. A tighter fiscal policy would help central banks meet their inflation targets with lower interest rates and would possibly reduce the risk of taming inflation without pushing European economies into a deep recession. In turn, this would reduce debt service costs and further bolster financial stability.

The second element is financial stability. This will require close supervision and monitoring of both banks and nonbank financial intermediaries, contingency planning, and prompt corrective action.

The third element is dealing with supply side bottlenecks. As we are facing a tight labour market across Europe, we need measures that could ease underlying inflation pressures. Besides quick wins like better job matching and more enhanced labour participation beyond retirement age, we need more focused and elevated investments to improve productivity levels and capacity.