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The spectre of inflation

Blog post by Isabel Schnabel, Member of the Executive Board of the ECB

Frankfurt am Main, 14 September 2021

Sentiment in the euro area is brightening. Consumers and firms are becoming more upbeat about the future. At the same time, consumer prices are increasing at a faster pace. In August, inflation in the euro area stood at 3%. In Germany, the inflation rate, as measured by the Harmonised Index of Consumer Prices, hit 3.4% in August – a level not seen in 13 years. And it is likely to continue rising until the end of the year.

These developments understandably have people worried. Higher inflation reduces purchasing power and lowers inflation-adjusted wages and interest income. Very low nominal interest rates compound these worries as commercial banks are increasingly passing negative interest rates on to their customers.

It is important to offer a factual explanation for the recent price increases and an assessment of future risks, especially in Germany where fearmongering is on the rise. Allusions are being made to conditions in the Weimar Republic and parallels being drawn with the 1970s. I will explain why these comparisons are misleading. There is not the slightest indication that the current monetary policy will lead to permanently higher inflation, let alone bring about hyperinflation.

The yardstick and compass of the assessment of the risks to price stability is our new monetary policy strategy, which was adopted unanimously by the Governing Council of the European Central Bank (ECB) in July. The key element of this strategy is a new, symmetric annual inflation target of 2% over the medium term, which replaced our previous aim of below, but close to, 2%. Our new target makes it clear that we consider sustained negative and positive deviations to be equally undesirable.

This clarification matters because, in recent years, our challenge has been inflation that was too low rather than too high. Since the global financial crisis, the inflation rate has averaged just 1.2% in the euro area, and 1.3% in Germany, significantly undershooting the 2% mark.

Price stability is also put at risk by inflation that is too low. Indeed, falling inflation and inflation expectations largely reflected the decline in the euro area’s long-term growth prospects. The economy was caught up in a vicious circle of limp demand, weak corporate profitability, poor wage increases and low price rises.

The decline in long-term growth and inflation expectations led to falling interest rates long before the ECB began purchasing bonds as part of its monetary policy. When interest rates are very low, monetary policy can no longer stabilise the economy in the same way in times of crisis. This is because central banks cannot lower interest rates indefinitely, as that would lead to a flight from bank deposits and into cash.

Even during the pandemic – despite it being the most serious crisis in post-war history – we did not lower the key interest rates any further. Instead, we supported the economy by purchasing bonds. These measures prevented a severe financial crisis and supported the financing conditions for firms and households, thus boosting growth and inflation.

However, using such instruments over a long period of time may cause side effects, because they directly interfere with the way financial markets work and can in the long run give rise to adverse incentives for governments and investors. Our new, symmetric inflation target can contain these risks in the future by preventing a lasting decrease in inflation expectations, and hence in nominal interest rates.

How is our new strategy affecting monetary policy in the current environment of rising inflation? We have set out two conditions for raising policy rates.

First, we will not react to short-term fluctuations. Inflation needs to stabilise at 2% on a durable basis. Despite the current high inflation rates, this condition is not yet fulfilled. We expect inflation in the euro area to noticeably weaken next year. This is because it is currently significantly affected by statistical effects. Put simply, inflation is so high now because it was so low last year. If we adjust for these base effects, inflation remains too low rather than too high.

The second condition is that we want to see our 2% target within close reach in order to avoid tightening our monetary policy stance prematurely, as that would certainly not result in a sustainable end to low interest rates. A premature tightening would choke the nascent recovery and once again jeopardise the achievement of our inflation target.

Nevertheless, we are diligently monitoring whether we might not be underestimating the possibility of higher inflation. Three developments call for our particular attention.

The first of these is related to the current commodity shortages and supply chain disruptions. The longer they persist, the greater the likelihood that firms will pass through their cost increases into consumer prices.

Second, increasing inflation expectations, higher wages and the enormous extra savings – representing over 7% of annual disposable income – may boost consumption.

Third, our models may not be able to appropriately reflect the structural impact of the pandemic. Not least thanks to the European recovery fund, the pandemic has accelerated digitalisation and the green transition.

Even in these cases, we do not expect inflation to be persistently too high. However, we may be able to reach our 2% target sooner, which would be good news for the euro area.

The ECB will continue to resolutely safeguard price stability in the euro area. We will vehemently counter persistent upward and downward deviations from our inflation target. In this way, we may finally be able to chart the path out of the low interest rate environment.

This blog post appeared as an opinion piece in the Frankfurter Allgemeine Zeitung on 14 September 2021.