The Challenging Path Ahead: ECB Navigates Inflation
Amid a global backdrop of surging inflation, the European Central Bank (ECB) is facing a formidable challenge in its quest to bring inflation back to its 2% target. The vice president of the ECB, Luis de Guindos, recently emphasised the difficulties of the final leg of this journey and dismissed any premature discussions of rate cuts.
The ECB has been grappling with the most significant spike in inflation in a generation, necessitating an unprecedented 10 consecutive increases in the deposit rate, elevating it to an all-time high of 4%. Despite recent data showing a two-year low in price pressures, De Guindos remains vigilant, citing the recent ascent of oil prices to a 10-month peak as a potential stumbling block. He asserted, “We are on our way towards 2 percent, that’s clear. But we must monitor that very closely, as the last mile will not be easy, and the elements that might torpedo the disinflation process are powerful.”
Besides oil, the ECB faces potential challenges from rapid wage growth, a weakening euro, and robust demand for services, all factors that could sustain elevated inflation levels. The delicate balance between these influences complicates the task at hand.
Eurozone inflation data for September indicated a decline to 4.3%, a figure lower than economists had anticipated. Despite expectations of a shrinking eurozone economy in the third quarter, which could alleviate inflation pressures, the ECB’s commitment to maintaining high rates for an extended period has rattled bond markets. This commitment was underscored by De Guindos, suggesting that interest rates would remain elevated for a considerable time.
De Guindos stressed the significance of the speed at which the ECB’s policy tightening translates into tangible impacts on consumers and businesses. Traditionally, changes in monetary policy take at least a year to fully affect inflation. Hence, if inflation remains stubbornly high and policy transmission is rapid, the ECB may consider further rate actions.
Although the cost of borrowing has surged, and loan demand has waned, there is uncertainty regarding how quickly these effects will reach households and companies. Many have locked in low rates for extended periods, offering them some insulation from the ECB’s policy tightening.
Additionally, increased government spending in nations like Italy and France is contributing to sustained price pressures. This spending has been bolstered by plans for larger fiscal deficits, surpassing EU limits. The ECB has expressed concerns about the impact of rising interest rates on property prices, especially in the context of financial stability, with non-banks, such as mutual funds, exposed to the property market.
The issue of “excess liquidity” in the banking system, amounting to about €3.7tn, has also sparked discussions within the ECB governing council. Some members have advocated for a faster reduction in this liquidity, which currently incurs significant interest payments to banks. One potential solution is increasing the minimum reserves banks must hold at the ECB. However, the ECB maintains that its monetary policy should be guided by price stability rather than the financial gains or losses of national central banks.
Speculation abounds regarding the possibility of earlier-than-planned reinvestments in the €1.7 trillion Pandemic Emergency Purchase Programme (PEPP), a bond-buying initiative instituted during the pandemic. While some ECB executives have advocated for quantitative tightening within the PEPP, these discussions are still in their infancy. Nonetheless, there is a prevailing sentiment that such measures may be implemented relatively soon.
In navigating these turbulent economic waters, the ECB faces a challenging path ahead, with the final leg of disinflation proving to be the most arduous. As global economic dynamics continue to evolve, the central bank must remain vigilant and adaptable to ensure stability in the eurozone.
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