Monetary policy in the euro area is now almost incomprehensible. The inflation rate is 7.5 percent, but the ECB still claims to expect 2 percent again for 2023. Even their own economists now admit that the models are unreliable.
Christine Lagarde at the spring meeting of the IMF in Washington: The ECB President wants to wait for new data.
Michael Rasch, correspondent for the “Neue Zürcher Zeitung” in Frankfurt
You are reading an excerpt from the weekday newsletter “The Other View”, published today by Michael Rasch, business correspondent for the NZZ in Frankfurt. Subscribe to the newsletter for free. Not resident in Germany? Benefit here.
The European Central Bank (ECB) has a problem: its inflation forecasts have been way off the mark for months. The inflation rate in the euro area is now 7.5 percent, the highest since the early 1980s. The problem comes as no surprise. Critics have been complaining for some time that the central bank may be systematically underestimating inflation.
This is probably mainly due to the fact that the models used for the forecast are heavily calibrated to the world before the pandemic. But the days of structurally low inflation are now a thing of the past. In addition, when analyzing existing trends, many models assume a return to the mean value in the near future, which may also cause problems in the current environment.
Energy prices as a core problem
This week, the economists at the ECB openly acknowledged the problems. According to the central bank’s most recent economic report, the incorrect forecasts reached their peak so far in the first quarter of this year, when the short-term ECB projection missed actual inflation by a whopping 2 percentage points.
As a result, the central bank had to almost double its inflation forecast for 2022. The significant underestimation of inflation began in the first quarter of 2021, and the problem became increasingly acute from the third quarter.
The ECB locates unexpected developments in energy prices in connection with the effects of the reopening of economic life after the corona pandemic has subsided and disruptions in global supply chains as the cause of the failure. Above all, the sharp rise in the price of oil, natural gas and electricity has caught the economists completely on the wrong foot.
High energy prices were then exacerbated by Russia’s invasion of Ukraine. The experts at the ECB also did not expect the high wholesale prices for energy to be passed on to consumer prices very quickly.
Overestimation of own forecasts
So are the economists at the European Monetary Authority simply too bad? At least they are definitely in prominent company. The US Federal Reserve (Fed) and the Bank of England, as well as numerous economists from commercial banks, were similarly far off the mark with their respective inflation forecasts.
However, the devastating thing about the ECB leadership around President Christine Lagarde is that she gives the impression that she hardly ever doubts her own forecasts. Accordingly, the ECB Governing Council still relies heavily on its own expectations when determining monetary policy to achieve the medium-term price stability target of 2 percent. Lagarde is taking a big risk with this.
To this day, the ECB Governing Council is captivated by the projections published in December and then in March, according to which inflation in the euro area will fall back to around 2 percent in 2023 and 2024. The ECB should now have this assessment fairly exclusively, especially with regard to next year.
Damaged reputation of the ECB
It damages the already tarnished reputation of the central bank if its monetary policy, despite the high inflation rate in the euro area – in several countries it is even well into double digits – continues to focus convulsively on its forecasts in order not to have to raise interest rates more quickly, while in the meantime even their own economists admit how poorly the models worked in exceptional situations.
It is good that the ECB is finally admitting the problems. But that’s not enough, because inflation is likely to remain high given the ongoing disrupted supply chains and the Ukraine war. For this reason, the Governing Council of the ECB should not wait stubbornly for the next publication of the forecasts in June, but act quickly and finally start fighting inflation. Every day that goes by unused is one too many.
You can contact business editor Michael Rasch Twitter, linkedin and Xing and NZZ Frankfurt Facebook follow.