Euro monetary policy: Lagarde: 7 percent inflation is possible

Europe's central bank does not want to follow the American Federal Reserve with rate hikes for the time being - but sees the danger of a further significant increase in inflation due to the Ukraine war.

At least in the short term, the impact of war and sanctions on energy prices should not be underestimated.

Christian Siedenbiedel

Editor in Business.

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That's what the heads of the central bank said on Thursday at the conference "The ECB and its Watchers", a meeting of central bankers and their observers in banks and science, organized by Frankfurt economics professor and economics expert Volker Wieland.

Already on Thursday morning, before the meeting, the European statistical office Eurostat had published that the inflation rate in the euro area in February was slightly higher than previously assumed in an initial estimate: the rate was 5.9 instead of 5.8 percent, after 5 .1 percent in January.

Above all, energy prices have continued to rise significantly.

War is likely to drive inflation further

Many prominent central bankers and academics were there – from ECB President Christine Lagarde to former central bank chief economist Otmar Issing, who has long been urging the ECB to tighten monetary policy.

On average this year, the ECB now expects eurozone inflation to average 5.1 percent, Lagarde pointed out.

In a more pessimistic scenario, however, the economists at the central bank also considered inflation of 7.1 percent on average in 2022 to be possible.

Lagarde said the war in Ukraine will at least further aggravate the short-term factors driving up inflation.

Since the beginning of the year, gas prices have risen by 73 percent and oil prices by 44 percent.

"Food inflation pressures are also likely to increase."

ECB chief economist Philip Lane said he still expects inflation to come back later, but not to the low pre-pandemic levels - in the medium term it will be closer to the central bank's inflation target of 2 percent.

The ECB sees itself confirmed in this assessment by the survey of professional forecasters.

Given the uncertainty, the ECB must rely on "flexibility" to be able to react to unforeseen developments, Lagarde said: "We hope for the best, we are prepared for the worst and we are not surprised by anything in between."

"New Era of Energy Inflation"

Despite high inflation, the ECB remains slower to return to normalizing monetary policy than the US Federal Reserve.

If nothing unforeseen happens, she wants to end her bond purchases in the summer and raise interest rates "some time afterwards".

ECB council member Klaas Knot has not ruled out two rate hikes in the current year.

Lagarde hinted that the ECB could also develop and deploy new monetary policy tools.

Lagarde compared the current inflation situation with the development after wars – and earlier energy price shocks.

"In many ways, the best analogy for what we've seen is the surge in inflation that typically accompanies the end of wars, when demand for consumer goods outstrips sluggish supply as businesses are slow to adjust to normal conditions," she said.

Between 1945 and 1947, for example, the price of crude oil in America rose by 80 percent – ​​when car ownership became more widespread, but the supply of oil could not keep up.

On the other hand, experience after Iraq's invasion of Kuwait in 1990 showed that higher energy prices put a strain on household budgets, which in turn could have a dampening effect on growth and inflation.

This "negative income effect" caused by rising energy prices already accounted for 1.4 percent of gross domestic product in the last quarter of 2021 - historical experience suggests that this effect will become even stronger.

ECB Executive Board member Isabel Schnabel spoke of a “new era of energy inflation”.

The Ukraine war once again illustrates the disastrous consequences of the West's dependence on fossil fuels.

This energy inflation included “climate inflation”, “fossil inflation” and “green inflation”.

The economist described the price-driving consequences of climate change itself as “climate inflation”, the rising prices of oil and gas as “fossil inflation” and the costs of the green transformation as “green inflation”.

There is still a lot to be expected for fossil fuel inflation: The embargoes imposed by America and Great Britain on Russian oil imports and the European Commission's plan to reduce Russian gas imports by two thirds by the end of the year are likely to have significant consequences.

"Green inflation", on the other hand, has so far been much less responsible for the increase in consumer prices, says Schnabel: "However, as more and more industrial sectors switch to low-emission technologies, it can be assumed that green inflation will exert upward pressure on prices in the transition phase. "

Monetary policy should not ignore any of this.

When measuring inflation, the central banks would have to take into account structural components of the rise in energy prices.

Measuring inflation, assuming that energy prices fell symmetrically in the same way they rose before, is just as little the right answer as raising the inflation target.

The role of monetary policy in this process is to protect people's purchasing power - by ensuring that the current period of high inflation does not become entrenched in expectations.