The Specter of Stagflation
Woes Grow for ECB in Battle Against Inflation
The European Central Bank is increasingly desperate in its fight against inflation. Will further interest rate hikes strangle the economy for good? Some are now looking to unconventional measures to turn things around.
By Tim Bartz, Michael Brächer, Kristina Gnirke und Claus Hecking
ECB President Christine Lagarde: "Humility in how we communicate is key to fostering trust." Foto: KAI PFAFFENBACH / REUTERSIf only everything could be as easily solved as the broken electrical system.
For the entire month of August, the European Central Bank (ECB) had to vacate its headquarters in Frankfurt's Ostend district so that workers could repair the building's ailing wiring, which isn't even 10 years old yet.
Central bank staff, unless on vacation, worked from home.
Now, the work will be completed just in time for the first post-summer interest rate decision, coming on September 14.
The power is flowing smoothly again and staff members are back in their offices.
The central bank's core problem, though, is still there, as stubborn as ever: towering inflation.
Inflation in the eurozone remained at 5.3 percent in August, which is higher than the ECB had been expecting.
Worse yet, the economy is slipping, especially in Germany , the largest member of the currency union.
Experts refer to such a situation as stagflation: The economy has stalled, but prices are still rising quickly, and there is no way out in sight.
It's a horror scenario for central bankers.
The dilemma has been developing for months.
And the team around ECB President Christine Lagarde, who initially underestimated inflation, have been fighting it for just as long.
The ECB has raised its key interest rates nine times in a row since July 2022 (see chart) – more often and more aggressively than at any time since its inception.
And inflation has indeed been cut by half since its record high of 10.7 percent in October 2022.
But it is still a long way from the 2-percent target the ECB has always stated as its goal.
And now the economy is buckling as well.
At ECB headquarters in Frankfurt, officials are struggling to find a way out of the dilemma.
The situation is coming to a head and is threatening to reopen old rifts in the ECB between the laxer monetary policy "doves" from Southern Europe and the more stability-oriented "hawks" from the northern countries.
Whereas the French, Italians and Portuguese are more or less open to taking a break from further increasing interest rates in order to avoid additional pressure on the eurozone economy, the German representatives in particular don't want to let up on fighting inflation with interest rate hikes.
"It's for me much too early to think about a pause," Joachim Nagel, the president of Germany's central bank, the Bundesbank, told Bloomberg Television.
But the overall tenor has still been civil compared to the years under Lagarde's predecessor Mario Draghi.
The Italian ECB president's penchant for going it alone poisoned the climate in the Governing Council, which is made up of the six-member Executive Board led by Lagarde and the heads of the 20 national central banks that are part of the eurozone.
Lagarde managed to pacify the ECB's highest decision-making body, and external shocks like the pandemic and the war in Ukraine seemed to bring the brittle guardians of the monetary union more closely together.
Even chief economist Philip Lane, who long thought inflation was a myth, was allowed to keep his job.
Now, though, Europe's economy and the ECB are at a crossroads.
The situation is the mirror image of that in the United States, where the economy is humming.
In Europe, it is limping.
In the U.S., inflation has now fallen below the key interest rates, but it has remained considerably higher here.
The situation is extremely complicated.
It's possible that inflation in the eurozone is in fact falling more quickly than the interest rate hardliners believe.
That could be the case if the economy slumps across the board and energy prices continue to fall.
Bank lending is already faltering, and the important M3 money supply is actually shrinking.
Interest rate hikes also take many months before they take effect.
The ECB's headquarters in Frankfurt's Ostend district: The building's electricity grid has been fixed, but the inflation problem is still there. Foto: Helmut Fricke / dpa"Generally, it takes one to two years for higher interest rates to show their full effect," says Sebastian Dullien, research director at the Macroeconomic Policy Institute (IMK) in Düsseldorf.
He also warns: "If the ECB raises interest rates too quickly, we risk plunging the European economy into a deep recession, especially in Germany."
It is possible that events will turn out differently and that inflation will become firmly entrenched in the long term.
If, for example, the economy counters the current wage increases with renewed price increases, which would in turn spur the unions on to new demands, causing the spiral to spin even faster.
The fact that such a scenario is realistic can be seen in the plans that consumer goods manufacturers have for the German market, previously a discount paradise.
Buyers for supermarket chains say that large brand-name companies are intending to jack up their prices even though production costs have begun falling again.
Global consumer goods suppliers in particular would like to finally push through higher margins – at the expense of consumers and at the price of higher inflation rates.
Central bankers, including Lagarde, have denounced such "greedflation," but they are powerless to do anything about it.
But what is true for Germany, the largest country and the most important inflation driver in the eurozone, isn't universally applicable.
The currency zone is far too disparate for that.
A look at Spain, where inflation rates are comparatively low, shows how complex the interrelationships, and thus the requirements for monetary policy, actually are.
In August, prices in Spain rose by just 2.4 percent, half the eurozone average.
The reason is that Spain's center-left government has eliminated the value-added tax on staple foods and halved it for other groceries.
Beyond that, Madrid has subsidized public transportation to lower ticket prices and capped rent increases and electricity prices – far bolder moves than those that have been undertaken by Berlin.
Housing costs alone fell by almost 15 percent in Spain in July relative to the same month last year because consumers have to pay less for electricity and gas.
The primary reason for this is that Spaniards often sign contracts for rates that are based on current wholesale market prices – unlike Germany, where households usually sign annual contracts with their suppliers at fixed prices.
Whereas electricity is still expensive in Germany because of old contracts, the Spanish, who have short-term contracts, are benefiting from the fact that market prices for natural gas and electricity have now fallen significantly.
Inflation in the fourth-largest economy in the eurozone is correspondingly lower.
Or are the numbers deceptive?
Things get tricky when you take a closer look at the "core inflation."
This calculation excludes energy and food, whose prices fluctuate greatly.
It is all the more significant for the euro watchdogs in Frankfurt because it smooths out the erratic swings in the picture of inflation it paints.
In Spain, core inflation, excluding price-dampening energy costs, was 6.1 percent in August – significantly higher than in Germany, where it is currently 5.5 percent.
So, how to deal with the cacophony of data?
The ECB is struggling to come up with a response.
Lagarde, whose primary quality is smooth communication, seems almost meek these days.
On Monday, the French ECB president said in London that the central bank needs to do a better job of explaining why it sometimes misses the mark with its inflation forecasts.
Otherwise, she said, it would be difficult to win back people's trust.
"Humility in how we communicate is key to fostering trust."
She also said that social media and the nonsense that is sometimes spread there is also making it increasingly challenging for the ECB to "disseminate factual information."
Forecasts Jettisoned
The ECB is sticking to its medium-term two-percent inflation goal, but it is otherwise taking a wait-and-see approach and deciding on key interest rates based on the most up-to-date data.
It will do the same on September 14, when it will have to choose between another small increase in the key interest rate to 4.0 percent or leaving the rate as it is for now.
At the same time, the ECB has jettisoned any long-term forecasts about its interest rate decisions – the outlook is too clouded.
On the one hand, this is understandable in light of the confusing economic and inflation indicators and the danger that the line between "doves" and "hawks" will deepen into a trench.
Right now, they're united by the fear that people's expectations for inflation will become "untethered."
Because as soon as a majority of consumers believe that inflation will no longer shrink to normal levels, the ECB would lose control.
On the other hand, the ECB is still far from reaching its goal.
"The ECB's inflation target is unlikely to be reached until 2026 at the earliest," believe analysts at the Leibniz Center for European Economic Research (ZEW) in Mannheim, for example.
Now, completely new models are being considered in central bank circles for curbing inflation.
Models that avoid constantly adjusting the interest rate in ways that could imperil the entire economy, increase unemployment and give fuel to populists who are already gaining the upper hand.
One possibility would be for the ECB to require commercial banks to increase their minimum reserves at the ECB.
Currently, they must park 1 percent of their customer deposits at the ECB in Frankfurt, and no interest is paid on that money.
This removes liquidity from the market and, although economists admittedly disagree on this point, weakens inflationary pressure.
Suggestions have ranged all the way up to an interest-free minimum reserve of 5 percent.
But Bundesbank head Nagel is giving the idea some consideration.
It has the attractive ancillary effect that commercial banks could no longer deposit this money with the ECB at the deposit rate and collect billions completely risk-free – a state of affairs that is causing widespread irritation.
In addition, the ECB could reduce its hugely bloated balance sheet by accelerating the sale of government bonds it holds.
The securities accumulated particularly rapidly during the pandemic to make it easier for eurozone member states to incur debt indirectly through the ECB.
It is true that the ECB has already started reducing its balance sheet total – an urgent wish of the "hawks" – although it has only done so in small doses.
Still, no major decisions have been made, and central bankers aren't known for hectic changes to their usual ways of doing business, anyway.
"Monetary policy is always most difficult at the beginning of a crisis and at its end, when it is time to pull out," says one central banker.
The only catch is knowing whether the end is actually approaching – or if you are only halfway there.
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