Inflation and interest rates: beware of monetary policy errors

A major reason why inflation was underestimated last year was the mistaken belief of some monetary politicians and economists that a significant and possibly only temporary increase in energy and food prices would not be reflected in the general level of consumer prices.

The untenability of this assessment was already evident during the last major wave of inflation around half a century ago.

Then as now, the proponents of this misconception sought arguments why monetary policy should by no means raise interest rates significantly.

It is no coincidence that the majority of them in Germany were economists who dream of abolishing the debt brake.

They advocate further debt-financed investment programs, be it at national or European level, and advocate the willingness of central banks to help debtors with bond purchases if necessary.

Today, these fallacies would like to convince central banks to stop raising interest rates soon.

Their argument is that the inflation rate is likely to fall significantly later in the year as last year's sharp rises in energy and food prices gradually disappear from the statistics.

That's not far off the mark, but unfortunately, the proponents of last year's fallacy are about to get it wrong once again.

Core inflation continues to weigh on consumers

Anyone who looks at forecasts for so-called core inflation, which disregards the volatile prices for energy and food, recognizes that there is still significant inflationary pressure on consumers' shopping baskets.

It is likely to increase further if the global economy develops better this year than previously forecast.

In any case, the economic researchers have long since wrapped up their most pessimistic forecasts.

The naïve notion that, once an inflation rate has started to fall, it will necessarily continue to fall until it reaches the target mark is supported neither by theory nor by empiricism.

The European Central Bank underestimated inflation for a long time, but has now adjusted its course to the situation and has announced further interest rate hikes in the future.

This not only hit some economists off guard, but also quite a few participants in the financial markets, where the majority of people are not happy about a significant rise in interest rates.

The reassessment of the ECB's policy is reflected in the foreign exchange market.

One euro now costs $1.08 there, which corresponds to an appreciation of the euro by around 10 percent since last autumn.

Today, of course, this appreciation helps in the fight against inflation, just as the previous devaluation had supported inflation.

A third error is in the room

The ECB's clearer stance was preceded by a change in the balance of power in the Governing Council.

The supporters of a loose monetary policy, who have long formed a majority, no longer dominate the monetary policy discourse of the ECB.

Chief economist Philip Lane has lost his power of interpretation;

Isabel Schnabel and Joachim Nagel are among the winners of the change.

The proponents of the fallacy will soon come up with another argument why monetary policy should not consistently continue the fight against inflation until the target of 2 percent is reached.

Claiming that the cost to the economy of tight monetary policy will become too great over time, they will advocate simply raising central banks' target from the current 2 percent.

However, this would now be the third error in a row, which is not only obvious to liberal economists.

In Davos, Larry Summers, one of the most prominent representatives of the Keynesian school, warned against changing inflation targets because this would undermine the credibility of monetary policy.

Monetary policy would be made more difficult by a strongly expansive financial policy.

For this reason too, plans for further debt-financed European investment funds should be viewed very critically.

Finally, the ECB must also significantly reduce its holdings of bonds.

However, a noticeable increase in debt in the euro zone would increase the risk that the ECB would have to act as a bond buyer again.

The timing would be extremely bad.