There has been a regime shift of late in terms of the relative importance of monetary and fiscal policy, writes economist Austin Hughes

As expected, the European Central Bank raised interest rates last week by 50 basis points. This brings its cumulative tightening to 250 basis points in just over seven months, the fastest pace of tightening in the ECB’s 23-year history.

The ECB also signalled that its policy rates are likely to rise by a further 50 basis points next month (the next policy meeting is scheduled for March 16 and that ‘the Governing Council will stay the course in raising interest rates significantly at a steady pace and in keeping them at levels that are sufficiently restrictive’.

As a result, it seems the ECB envisages material further tightening moves into the summer and possibly beyond.

In response to a question at the  press conference as to whether March might reach the peak in rates, ECB president Christine Lagarde firmly replied, ‘No, no, no. We know that we have ground to cover. We know that we are not done’.

While the messaging from the ECB is very clear, it was less stringent than in December, and the economic environment is changing materially. I remain hopeful that further evidence that we are clearly past peak price pressures will build, albeit unevenly, in coming months.

In Association with

This may be accompanied by more persistent softness in activity. Such a scenario could limit additional ECB rate increases of one 25 basis point hike (in line with my previous expectations) or possibly two. 

A peak or at least a pause the rate hike cycle might also be brought closer by circumstances where policy will also be tightened from March by the start of a ‘balance sheet normalisation’ entailing a reduction in the securities the ECB currently holds through its Asset Purchase Programme. 

Banshee cries wolf 

The banshee of Irish folklore wails to warn of impending disaster. For much of the past year, that disaster was judged to be runaway inflation. That risk now looks overdone.

Instructively, the ECB statement speaks of the need to guard against the risk as opposed to the reality to a rise in inflationary expectations.

If the ECB raises rates aggressively further, it is unlikely to substantively alter the path of inflation but it could trigger more problematic developments in relation to economic activity and/or financial stability.

Again, we are talking about risks rather than reality in terms of damage from ECB policy overkill.

However, given the sequence of shocks visited on households and firms through recent years, it can’t be assumed that after a decade or more of largesse, ongoing monetary tightening may not pose material problems. 

With preliminary estimates showing headline inflation in the euro area at 8.5% and underlying inflation at 5.2% in January, current price pressures are clearly entirely inconsistent with the ECB’s target of 2%.

In turn, this argues that ECB monetary policy could not remain at the ‘emergency’ settings of a year ago. But given the scale and speed of policy adjustment through past seven months, it is questionable if it needs to be much more restrictive than it is at present.

Already, headline inflation is easing, and underlying inflation largely seems to reflect the partial feed-through of specific pulses from soaring energy costs, supply chain disruptions and war in Ukraine.

In each instance, it is to be expected that the scale and speed of recent price shocks would spark a marked change in business costs that would feed through to an adjustment in ‘downstream’ prices for a range of goods and services.

However, the evidence thus far is that such price mark-ups and related wage-bargaining ‘catch-up’ (that the ECB cited) are reasonably contained.

Uncertain demand conditions and related caution in wage setting mean the feed-through of the various price shocks is likely to be material but limited in terms of degree and duration.

Recent signs of a downward correction in relation to energy and supply chain impulses could amplify a disinflationary process, although we would emphasise the path in coming months could be quite bumpy.

Policy rethink required

The reality of stronger than expected economic growth and lower than expected inflation in the euro area in recent months also hints at something of a regime shift of late in terms of the relative importance of monetary and fiscal policy.

Substantial fiscal policy actions have sustained the spending power of euro area households in recent months. Large interventions in terms of energy supports have both reduced energy price inflation (as seen most forcefully in the case of Germany) and lessened the rationale for aggressive and disruptive attempts to maintain pricing or purchasing power. 

The much increased and relatively successful role of fiscal policy in recent years means broader questions are now being shaped as to how fiscal and monetary policy should interact in the euro area (and elsewhere) in coming years to deliver more stable and sustainable trends in activity and prices.

Photo: Austin Hughes