There was a time when inflation stopped being a policy and public concern. This time started with the so-called ‘Volcker shock’ in the 1980s when US Federal Reserve chairman Paul Volcker successfully led global central banks to fight rising prices with rapid interest rate increases.
This did tame inflation but at a high unemployment cost, and was followed by two decades of the Great Moderation when central banks secured both low inflation and stable economic growth.
Since the 2008 global financial crisis – and in the initial phase of the COVID-19 pandemic – central banks have been mainly concerned by inflation being too low, especially in the eurozone where stubbornly low-price level increases have defied European Central Bank (ECB) attempts to meet its two per cent inflation target for almost a decade.
But that era could now be at an end as consumer price inflation reached 5.1 per cent in January in the eurozone, putting inflation firmly back in the spotlight.
Although energy prices are by far the largest contributor to this rise – increasing by almost 30 per cent compared with January 2021 – wider inflationary pressures have also become visible, even when looking at measures of inflation that exclude energy and food prices.
Monetary policy is changing
In the US and UK inflation has been even stronger and as a result the Bank of England and the US Federal Reserve have already started retreating from the extensive monetary accommodation which has characterized monetary policy for the past decade.
Recently the ECB signalled it is ready to follow in the footsteps of its peers, suggesting it will reduce the pace at which it buys government and other bonds and that it might increase interest rates in 2022.
But this ECB ‘policy pivot’ comes with enormous challenges, some which are similar to those facing its peers, but others are more distinctive as they derive from the political-economy characteristics of the eurozone and the supranational nature of its central bank.
Along with its peers, the ECB must get the inflation outlook ‘right’ – hardly an easy task under normal circumstances, but even tougher after an unprecedented pandemic-induced crisis.
The ECB must look beyond the current price increase to gauge how persistent it will be over the medium term and whether there is a risk of inflation expectations de-anchoring from the two per cent target.
But a definitive assessment is currently out of reach as conflicting forces are at work in the eurozone. Energy costs are pushing inflation higher but tend to be volatile and so could fall. And global supply chains have not fully recovered from the COVID-19 scars, so it is not yet clear whether increases in other spending categories are related to this and therefore probably temporary.
Although expectations can change, and fast, there is no evidence yet that wages are rising rapidly and so there are no signs of a wage-price spiral pushing up inflation in an uncontrolled manner.
The ECB needs to get the intervention right – too much monetary tightening or doing it too quickly could easily erode prospects of a sustained economic recovery. Although this challenge applies to all countries, it is especially the case for the eurozone, where the recessionary effects of the 2008 market crash were followed by a relatively muted recovery and a long period of modest growth.
The ECB often takes part of the blame for this poor economic performance, especially given its ‘too little, too late’ monetary accommodation, but economic discontent has in turn fed an unusually large public distrust towards the ECB.
Should the ECB policy trigger a slowdown in economic activity now, just when it had gained steam, it will be an easy target for public discontent and politicians looking for a scapegoat.
Economic diversity across the eurozone
The ECB also faces the challenges of getting eurozone economic diversity right. Although inflationary pressures are generalized, important differences exist in the economic conditions across eurozone countries and in their main vulnerabilities.
In this context, the implications of the end of monetary accommodation are not the same across countries. Monetary tightening can be much more severe for high-indebted member countries in terms of financial stability and economic growth.