ECB and governments face a credibility challenge on inflation

In Europe, inflation close to 10 per cent had not been seen for 40 years. The price increases, which started with the post-pandemic production bottlenecks, were further pushed by the energy crisis linked to the invasion of Ukraine. Core inflation, the measure without the more volatile components (including energy), also rose well above the ECB’s target, approaching 6 per cent. The return of inflation therefore raises important questions. How long will it last? Are we going back to the 1970s when, after the oil shocks, inflation remained high for a long time?

The answer depends on the actions of central banks and tax authorities. Although energy shocks mechanically impact inflation as they appear, the evolution of inflation depends on what firms and workers expect for the future. If businesses and consumers expect inflation to be contained, then they will negotiate prices and wages as in the past, and inflation will come back under control. If, on the other hand, they expect widespread price increases, then they will negotiate high prices and wages, persisting in a shock that may have been temporary. Moreover, high price increases lead to random redistributions of wealth, without solving the original problem of energy price increases. Trying to shift the increases to someone else is in vain because the rise in energy prices does not depend on internal factors, and neither monetary nor fiscal policy can prevent the bill from being paid.

It is therefore evident that multiple scenarios can follow the initial shock, depending on the expectations on the future by companies and savers.. The different experiences of European countries in the 1970s, in the face of practically the same energy price increases, are an example of this. The function of central banks in these situations of great uncertainty is to coordinate public expectations by anchoring all price increases around a common level of low inflation. If inflation expectations get out of hand it will become even more expensive to bring them back under control.

Information on near-future inflation expectations for the euro area, derived from surveys of financial operators, households, and stock prices, paints an uncertain picture. The median of expectations for next year is close to 5 per cent, it is lower over the following horizons. At the same time, the distribution of expectations is asymmetrical: the weight of operators who expect inflation to remain above 5 per cent, or to exceed the ECB target in the next 5 years, is growing. It is essential that monetary policy continuously monitors the evolution of these magnitudes and does all it can to curb the un-anchoring signals implicit in the dynamics of wages and prices. The credibility of monetary institutions, in Europe and elsewhere, is a hard-won asset that must be preserved. Full cooperation of fiscal policies is absolutely necessary. Issuing contradictory or confused signals, of new budget deficits or dissent on the way forward, would help reduce the credibility of anti-inflation targets, as has happened in the UK in recent weeks.

The European Central Bank faces a difficult choice: on the one hand, the risk that the markets will swell the ranks of those expecting high inflation. On the other hand, there is the risk that the continuation of the restrictive measures, the effects of which are slowly unfolding, will contribute to the economic slowdown already underway. The second consideration suggests caution. But the nervousness of the markets and the movements in the high tail of the distribution of expectations remind us that we are in a crucial moment for credibility, which must be defended without hesitation. This objective requires continuous and transparent communication with the markets, and a policy that is ready to support, with words and deeds, the increases in interest rates necessary to contain the pressure on prices. What happens depends on these choices.

Francesco Lippi
economist, Luiss University