If economists predict that inflation will not rise, how to interpret these data? If they are wrong, they will say: okay, we have made a mistake, or they will just say that the increase in inflation will be a temporary phenomenon. If even this prediction turns out to be incorrect, they will say: we have caught a crab again this time, which means: we aim to overcome for a certain period of time, given that we have enjoyed a long period of very low inflation. And if the overshoot proves to be lasting, they will say: sorry, we have blundered once again, or: better inflation at 10 percent rather than unemployment at 10 percent? I really don’t think it takes a genius to understand where certain speeches are headed. All those who swear that inflation will not rise are almost always the same people who will not be harmed in the least if it does rise.
By this I do not mean that I believe there will be an increase in inflation – or a decline in it. Frankly, I don’t know. However, I see that inflation could start to run again in the United States, and that its recovery risks triggering indirect repercussions in the euro area. One scenario predicts an increase in the price level in global supply chains not linked to the euro, but without an equal compensatory increase in the euro exchange rate in real effective terms.
It is also possible that counter deflationary forces could neutralize or overcompensate. There is no single indicator capable of telling us what will happen. When monetary aggregates, such as the infamous M3, rise over longer periods, this could be significant. Or completely insignificant. It depends on whether the money gets sucked into the financial sector or ends up pushing consumer prices higher. A quick calculation is to compare the amount of the US economic stimulus package with the gap between actual and potential output to conclude that the fiscal and monetary stimulus is too high. And yet the gap between actual and potential output represents a very problematic indicator, as we have learned from what happened in the euro area during the sovereign debt crisis. As for myself, I have forced myself to maintain an anti-dogmatic attitude.
So what, or shouldn’t we worry? The categorical answer: absolutely not. But we must not be caught unprepared. For the ECB, this means developing a strategy and communicating it in time. There is a real risk of a lack of communication in the future. If the ECB’s Governing Council blindly follows the Federal Reserve into the promised land of wanting to set average inflation targets, it would not be a surprise to see a permanent deviation from the 2 percent target. Rational minds can also argue over the exact definition of price stability. In my infographic, I have listed a number of alternative goals and policies. At the moment, the ECB is grappling with an endless review of monetary policy, which aims to identify a target to replace the current one.
Once the target has been set, the next step will be to define a strategy for the political action necessary to implement it, should inflation overrun occur. At the moment, the ECB is using a vast array of unconventional monetary policy instruments: the purchase program linked to the pandemic emergency; the ordinary asset purchase programs still in force; zero interest rate policies with its highly calibrated rules; targeted long-term refinancing operations to persuade banks to lend to the private sector. as if a Ferrari were launched at full speed against a construction site on the motorway: taking your foot off the accelerator pedal may not be enough to reduce speed in time.
If inflation overshoots, the ECB will have to end the PEPP, perhaps abruptly. And perhaps it will be forced to gradually reduce the ASP too, in the sense of a gradual reduction of equity assets, and not just net purchases. To achieve this, it is not necessary to go through the sale of existing securities, it is sufficient not to replace them after their collection.
Next comes the zero interest rate policy. In my view, the ECB will first start by canceling unconventional policies, such as asset buying, and only then push interest rates up again. The two interventions, however, could also proceed in parallel. In any case, it would be desirable to abandon the communication strategy on forward-looking indications. it was useful to the ECB during the sovereign debt crisis because it helped shift expectations in one direction. In normal situations, where central banks do not know which direction future policies will go, it is essential that they do not let themselves be tied up. The perspective indications are equivalent to a Ferrari launched at 300 km per hour with automatic pilot.
what will happen? No I do not think so. In my opinion, they will do anything to get by. The nightmare scenario is the following: adjustments will be too slow, and the inflation target will be exceeded. Monetary policy will then become fiscal dominance, a situation in which the fiscal stance of euro area governments will reduce the scope of all monetary policy decisions.
If we are lucky, there will be no inflation, or it will be a passing problem. But if inflation continues to rise and the ECB does not have a solid and effective strategy in place, we will all find ourselves plunged into that nightmare scenario.
(Translation by Rita Baldassarre)