CENTRAL BANKERS in Frankfurt may be feeling a little discombobulated. Having struggled to revive too-low inflation for the best part of a decade, they now find themselves hoping that too-high inflation will die down. Since the pandemic struck, the European Central Bank (ECB) has bought nearly €2trn ($2.3trn) in government bonds in order to soothe markets and gin up the economy (see chart). Now it must consider whether such quantitative easing (QE) remains appropriate. That involves grappling with two questions at its next policy meeting on December 16th: whether the euro area has truly escaped its low-inflation trap, and whether asset purchases have outlived their usefulness. The first is easier to answer than the second.
Inflation in the euro area, as in much of the rest of the world, is soaring. Consumer prices rose by 4.9% in November, compared with a year ago, the fastest pace in the history of the single currency. Many of the ECB’s rich-world counterparts, including the Federal Reserve and the Bank of England, are worried that inflation could become entrenched. In the euro area, however, the greater likelihood is perhaps that, once disruptions from the pandemic fade, it still undershoots the ECB’s 2% target.
To see this, consider the differences between economic conditions in the euro zone and America. There is less evidence of booming demand in Europe. Output is still slightly below its pre-covid level, whereas it is well above it in America. Fiscal stimulus in the euro area has been less generous.
Meanwhile, one-off disruptions seem to have played a bigger role in Europe. About half the inflation rate in November reflected surges in food and energy prices, which are unlikely to last. Other pandemic-related factors, including a temporary value-added-tax cut in Germany last year, have also played havoc with the base used to calculate annual inflation. Strip these out, by comparing “core” prices today with those in 2019, and annualised inflation falls below 1.5%, said Fabio Panetta, a member of the ECB’s council, in November. (The measure exceeds 3% in America.)
Hawkish types would argue that even temporary disruptions could generate “second round” effects, by becoming embedded in wage demands. But a strong pickup in wage growth is yet to materialise, and measures of inflation expectations are, on average, just below 2%. After its year-long strategy review concluded in the summer, the ECB promised to raise interest rates only if it expected inflation to reach 2% in the coming one to two years and stay there. Those criteria do not seem to have been convincingly met.
What about the need for QE? The Bank of England is soon due to stop making new bond purchases; Jerome Powell, the head of the Fed, has said that he will start to taper purchases more quickly. But in the euro area the answer is muddy precisely because the inflation picture is different. Some on the ECB’s council, including Isabel Schnabel, point out that the unwanted side effects of asset purchases are rising, and the gains are diminishing. The ECB will therefore be better off providing guidance on its interest rates to steer markets. One undesirable consequence of QE could be that central banks are now big players in government-bond markets: the ECB holds more than 40% of outstanding German and Dutch sovereign bonds, according to estimates by Danske Bank.
The expiry in March of one of the ECB’s bond-buying schemes, which was intended to counter the financial-market effects of the pandemic, could provide an opportunity for the ECB to stop expanding its footprint in bond markets. But not everyone agrees on the need to scale back asset purchases. Many economists expect the ECB instead to top up another existing asset-purchase programme in the coming months, so as to ensure that bond-buying does not tail off too rapidly. Mr Panetta has worried that too sharp a reduction in asset purchases could lead to a “premature increase in long-term interest rates”. In other words, if the ECB’s ultimate problem is that inflation is too low, rather than too high, then it may not have the luxury of doing away with QE. ■
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This article appeared in the Finance & economics section of the print edition under the headline “Emergency exit”
Source: Finance - economist.com
