The Unhappy ECB

All happy central banks are alike; each unhappy central bank is unhappy in its own way   (with apologies to Leo Tolstoy)

As the world enters 2022, the WHO holds out hope that Covid will finally shift from pandemic to endemic by mid-year. Omicron, the latest variant and currently seemingly the scariest as case numbers rocket across the world, may yet turn out to be the start of better news: as a variant which is both much easier to catch (thus driving out other variants) but also on the evidence so far easier to survive (thus creating herd immunity in the surviving general population), it may well signal the transition of the disease from terrifying killer to just another nasty virus that people catch from time to time, and then usually recover from.

For most of us, this is surely good news. It means that society can move on from the blunt response of lockdowns, of stopping all human activity in its tracks whenever the virus strikes. It also means that governments and others in authority will as 2022 progresses have an increasing ability to address the myriad of other issues that need attention, but which have been starved of it over the last two years. There is certainly a large enough backlog of “any other business” for them to focus on.

For one community in particular, the world’s central banks, this means only one thing: it is time to confront the issue of inflation. There is an old axiom for central bankers that “the time to become serious about inflation is when it moves from the business pages of the papers to the general pages” – this it has certainly done, and high and accelerating inflation in most advanced economies is rapidly becoming the key issue facing economic policy decision makers, even more so than surviving the economic consequences of lockdowns (which dominated their thinking in 2020) and plotting the economy’s recovery (which in turn dominated 2021).

In the United States and the United Kingdom, this process is well under way, and the thought that inflation is “transitory” and will subside of itself is losing credibility. The Bank of England has already raised interest rates once and the Federal Reserve is poised to do so. True, as pointed out in a previous Comment on our sister site Stein Brothers[1], as long as real interest rates remain substantially negative, the impact on inflation will be limited; but it is at least a start. If a happy central bank is one that is or is at least on the way to achieving its target, then inflation-targeting central banks that are tightening monetary policy in order to bring down above-target inflation, should feel at least somewhat happy.

However, there is one glaring exception to this happiness. That is the European Central Bank. Here, the view that “inflation is temporary and will fall back to target by itself” still reigns supreme. This is peculiar. The ECB is by far the most securely independent central bank in the world. The Chairman of the Board of Governors of the Federal Reserve, although nominally independent, can be told by the President of the United States to stop worrying about the (relatively small) number of unemployed and start worrying about the (very large) number of employed who are suffering from inflation. The Bank of England’s independence is more recent and more fragile: Andrew Bailey, the Bank’s Governor, is acutely aware of what Rishi Sunak thinks and even if theoretically he is allowed to ignore it, in practice he does not.

But the ECB, with its independence set out in an international treaty, is on the whole shielded from such pressure. If anything, the history of the Euro Area rather shows the central bank scolding politicians and urging them towards fiscal probity. If any central bank should be fighting inflation whatever the politicians think, it should be the ECB; that was after all how the ECB was set up to be – indeed, how the whole idea of a European-level central bank was sold to the Germans in the first place.

So why is the ECB so reluctant to act on inflation? It is not as if they do not have good cause to:  the latest figures show that inflation for the Euro Area (EA) as a whole hit 4.7% in November, and producer price inflation is above 20% (year to October). Meanwhile, German inflation reached a 39-year high of 5.3% in November, having been above the 2% target since April (figures are for CPI on a seasonally and calendar adjusted basis; source Bundesbank).

This ought to be reason enough for substantial ECB unhappiness and moves long since to bring inflation down to target, the more so since the ECB loudly proclaims that it has not adopted the American idea of “average inflation targeting”, ie, accepting a temporary (dare we say “transitory”?) overshoot to compensate for past undershoots. But still they do nothing, continuing their expansionary asset purchases and maintaining their key official lending rate at 0.00% (it is worth recalling that when inflation in Germany was last this high, in 1982, Bundesbank’s official lending rate was 7.50% – a very different monetary response!)

So we repeat, why is the ECB so reluctant to act? We think the answer might be a fear that the political consequences of trying to bring down inflation aggressively might exceed the economic consequences of continued inaction. And behind this, we sense a fundamental change in the ECB itself.

This needs some explanation. One of the key features of the pandemic has been a surge in EA government debt, notably (though not exclusively) in southern Europe. According to The Telegraph, France’s debt/GDP ratio is currently 118%; Spain’s is 120%; and Portugal’s is 135%. Much more worryingly, Italy’s is 155% and Greece’s debt/GDP ratio, after repeated restructurings and write-offs, is 206%!

These are alarming figures, and even more concerning for the ECB will be the contrast with northern Europe, where most notably, Germany’s debt to GDP has risen just 4 percentage points in the same period, from 65% to 69%.

As a result the ECB is basically trying to provide one monetary policy for two very different economies, one very heavily indebted and one rather less so.  And this is far from easy; simply put, raising interest rates to control inflation in eg Germany will rapidly erode the viability of government finances in many of the EA’s other member countries, leading to political consequences that ECB President Christine Lagarde, more of a politician than a central banker, will be well attuned to[2].

So what is the unhappy central bank to do? Should the ECB fight near-term inflation at the cost of wreaking fiscal havoc; or allow inflation to continue and risk it becoming entrenched? For the moment, the ECB seems content to adhere to Mr Micawber’s dictum. Mr Micawber, as our readers may recall, was the serial financial failure in Charles Dickens’ novel David Copperfield, whose constant motto in the face of adversity was “Something will turn up”. (As it happens, it did; he was transported to Australia and became a success there. But David Copperfield is a work of fiction).

Something may indeed turn up and save the ECB from its dilemma. But a far more likely outcome is that at some stage, probably before mid-year, the ECB will have to make an active choice. And that choice will by then almost certainly be to withdraw the monetary stimulus completely and begin to tighten policy, because nothing in the current monetary data supports the view that EA inflation will slow on its own.

True, EA broad money growth (M3) has come down from a peak of 12.5% in January 2021, to 7.3% in the year to November. But this is still well above pre-pandemic rates. Moreover, on three- and six-month annualised bases, a better guide to recent trends, M3 growth is accelerating again, this time accompanied by a pick-up in bank lending to the non-bank private sector, notably housing loans. As yet, this rise in credit is not particularly strong (roughly back to pre-pandemic levels), and perhaps more of a straw in the wind. But the important point is that, as long as real interest rates remain negative and as long as broad money growth remains at current rates (let alone accelerates), there is no reason why inflation should subside of itself.

How will inaction in the face of decades-high inflation go down in Germany? Presumably not very well. But what will, indeed what can Germany do about it? Events ever since the Global Financial Crisis (now 14 years ago) have shown that Germany’s clout in the ECB is very limited, with policy frequently taking turns that the German representatives on the ECB’s Governing Council (always two, the President of the Bundesbank and one member of the ECB Executive, but still only two out of 25) are unhappy with but cannot change. Germany could of course leave the euro; but that is the nuclear option, and short of that, the only other option is to perhaps not grin, but at least bear it.

And this highlights the other observation we would make, which is that Germany’s inability any longer to shape the ECB in Bundesbank’s image is part of a wider evolution: the ECB itself is in the process of transition.

When the ECB was set up, it was consciously modelled on the Bundesbank (including being domiciled in Frankfurt). This was partly to assuage the well-known German aversion to inflation. But it was also because the ECB was supposed to be a Teutonic, inflation-wary, prudent, rule-driven central bank. However, it is now well on the way to becoming what one might call a Latin central bank: less driven by rules than by flair and ad hoc decision-making, certainly not enamoured by inflation, but acutely aware of the damage that acting too rigidly on the anti-inflationary rhetoric would do to the national economies of EA member states.

This change has never formally been announced, and probably not even consciously agreed by the ECB’s Council as a policy objective. But it is clearly happening, and we shall explore it in more detail in a second essay next week. We hope to be able to shed light on why it is happening; whether it will bring happiness to the Euro Area is a different issue.


[1]              See “Negative real rates will not dampen inflation”, Stein Brothers, 30.11.21

[2]              As a secondary consequence, it would also erode the value of the bonds purchased by the ECB, thus threatening its equity and potentially forcing it to ask member governments for a capital injection. This is not crucial but would be embarrassing and possibly infringe on its independence.