[Lucrezia Reichlin] Europe’s monetary over-tightening trap

Headline inflation is falling fast in the United States and the eurozone, following a succession of sharp interest rate hikes by the US Federal Reserve and the European Central Bank. But monetary policymakers on both sides of the Atlantic have made it clear that they are not done yet. Are they going to go too far?

Core inflation, which is still running at around 5 percent in the US and the eurozone, remains a major cause for concern. Central bankers fear that, given a resilient labor market, high core inflation (which excludes food and energy prices) risks fueling a wage-price spiral and a de-anchoring of inflation expectations. As we learned in the 1970s, this could make inflation very difficult -- and costly -- to tame, with central banks facing the related challenge of regaining lost credibility.

Given this, policymakers seem to have concluded that the risks of doing too little to tighten monetary conditions are simply too high; better to err on the side of over-tightening. The ECB has expressed this view with particular clarity. But the ECB must not underestimate the risks, both to the eurozone economy and its own reputation, of being wrong. And wrong it may well be.

In the eurozone, the inflation spike of early 2022 was driven mostly by supply shocks, which triggered large relative price changes: the energy shock was larger in Europe than in the US, and the fiscal response was smaller. Moreover, as a net energy importer, the European Union has been hit by a negative terms-of-trade shock, which has reduced real disposable income.

But now the supply disruptions that triggered price growth have eased, and monetary tightening is taking effect. Yes, core inflation remains elevated. But as my co-authors Veronica Guerrieri, Michala Marcussen and Silvana Tenreyro and I show in a new report, this is to be expected, owing to the adjustment mechanism of prices across sectors.

Because energy shocks and supply-chain disruptions affect different sectors with different degrees of intensity, they lead to a reallocation of resources across sectors, carried out via relative price adjustments. But the prices of goods and services are sticky, and different economic activities are linked by complex input-output linkages. As a result, disinflation will not take hold immediately in all sectors. Particularly in the services sector, which is affected only indirectly by higher energy prices, prices tend to increase with a lag and inflation falls slowly.

Given this, one would expect core inflation to remain elevated for some time before it wanes. But there is little reason to try to accelerate that timeline. On the contrary, aggressive measures to reduce average inflation would kill the adjustment process and create inefficiencies. We know that excessive monetary tightening weakens demand, but by disrupting the reallocation of resources, it would also weaken consumption by undermining efficiency.

This is the last thing Europe needs. In the second quarter of this year, industrial production deteriorated rapidly, and indicators of credit conditions have been very weak. Consumption and investment in the EU, unlike in the US, are still below the trend estimated in 2019. Many, including central bankers, have voiced concerns about the effects of further pressure, let alone another recession, particularly in Italy and Portugal.

Unlike the Fed, which has a dual mandate, the ECB has one primary objective: price stability, defined as 2 percent inflation over an undefined “medium term.” This may explain why the ECB’s evaluation of the balance of risks shows a bias toward tightening. But having a primary objective does not mean that nothing else matters: the ECB also has a treaty obligation to support the broader economic objectives of the EU.

So, when the ECB is designing a policy aimed at achieving price stability, it should also account for secondary costs -- in areas like consumption, employment and financial stability -- that may undermine the EU’s ability to achieve other objectives. In fact, those costs should help determine how long the “medium term” turns out to be. The higher the costs, the longer the time horizon for delivering price stability.

But the ECB seems to have a more rigid interpretation of its price stability mandate. Rather than adjusting its approach to support other objectives, it has called for tighter fiscal policy to support its fight against inflation. Policymakers seem to have learned nothing from the events of 2011, when oil-driven inflation and deteriorating conditions in the real economy spurred the ECB to implement two interest-rate hikes and urge fiscal tightening. The result was a recession that, coupled with sovereign debt and banking crises, fueled widespread anti-EU sentiment.

America’s economy appears to be more resilient than Europe’s, possibly owing partly to the massive fiscal support implemented during the pandemic. In fact, it increasingly looks like the US will achieve a soft landing, bringing inflation back to the Fed’s target without triggering a recession. Unless the ECB embraces a more patient approach to its price stability mandate, Europe may not be so lucky.

Lucrezia Reichlin

Lucrezia Reichlin, a former director of research at the European Central Bank, is a professor of economics at the London Business School and a trustee of the International Financial Reporting Standards Foundation. -- Ed.

(Project Syndicate)