Is the ECB really that much of an outlier?

The last time German inflation was as high as it is now, in June 1992, the Bundesbank’s benchmark lending rate, the Lombard rate, was 9.75 per cent. Today the European Central Bank, the Bundesbank’s successor, is charging banks in Germany, as well as the wider eurosystem, zilch.

A lot has changed since the summer of 1992. Twenty-nine years ago, the unified German state was in its infancy and monetary union was yet to be born. It is, according to a note out Tuesday from research outfit Laburnum Consulting, the latter of these two changes that does more to explain why the gulf between rates then and now is so vast.

As we enter 2022, the ECB is breaking with another tradition. For the first time in more than a decade, policymakers in Frankfurt are mapping a different course to that being taken by the Federal Reserve and the Bank of England, each of whom is either hiking interest rates or set to consider them in the next few months in response to the spike in inflation witnessed over the past year. The ECB, meanwhile, is set to leave rates on hold for the duration of this year. The Laburnum note — written by Laburnum founder and former Bank of England official John Nugée and economist Gabriel Stein — thinks this is in part because the eurozone’s monetary guardian is setting policy with the region’s more heavily indebted sovereigns in mind:

Why is the ECB so reluctant to act? We think the answer might be a fear that the political consequences of trying to bring down inflation aggressively might exceed the economic consequences of continued inaction. And behind this, we sense a fundamental change in the ECB itself…

One of the key features of the pandemic has been a surge in EA government debt, notably (though not exclusively) in southern Europe. According to The Telegraph, France’s debt/GDP ratio is currently 118%; Spain’s is 120%; and Portugal’s is 135%. Much more worryingly, Italy’s is 155% and Greece’s debt/GDP ratio, after repeated restructurings and write-offs, is 206%!

These are alarming figures, and even more concerning for the ECB will be the contrast with northern Europe, where most notably, Germany’s debt to GDP has risen just 4 percentage points in the same period, from 65% to 69%.

As a result the ECB is basically trying to provide one monetary policy for two very different economies, one very heavily indebted and one rather less so.

This, Nugée and Stein argue, is set to lead to the ECB coming under fire, yet again, in the German popular press for favouring the currency zone’s more profligate members, at the expense of the more parsimonious.

We agree that this narrative is likely to play out. And it may, as the months roll on, seem as though the ECB is reluctant to remove support for reasons which economic factors alone fail to explain.

While workers here are yet to experience the sort of wage growth their American counterparts have, there are increasing signs of tightness in the labour market. Here’s a chart from an email from Nomura’s economists, which piqued our interest when it landed in our inbox in mid December:

However, while the ECB is an outlier in terms of its plans for the coming year, the central banks may still have far more in common with one another than they do earlier generations of policymakers.

Despite the shift in rhetoric from the Fed, the yawning gap between rates now and rates then is a similar magnitude in the US and Germany. The last time US inflation was above 6 per cent, in the autumn of 1990, the effective federal funds rate was around 8 per cent. Today it hovers above zero.

There’s a chasm between where rates are right now and where they were the last time we saw inflation as high as it currently is.

There are good reasons why they don’t need to be as high today as they were in the early 1990s. For instance, governments, firms and households are now more indebted — relatively small rises in rates will have a bigger impact on behaviour than in the past. Price pressures may be a different beast this time around too. Some of the inflation we’ve seen of late is in markets for goods such as used cars. Such inflation is linked pandemic-related supply shortages and may well disappear as businesses adapt to a world with Covid-19.

Still, a question hovers over the degree to which aggressive fiscal spending and monetary easing has led to something more enduring happening to inflation than chinks in global supply chains alone can justify. Rates don’t need to rise as high as 10 per cent. But if (and — in our view — it remains a big if), higher inflation becomes endemic, then they are going to need to rise an awful lot higher than any monetary policymaker is owning up to.

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