This week, we learned that the ECB has reverted to type. It’s going all-out to crush inflation, even at the risk of causing a recession. 

At its December meeting held this week, it announced a 50 basis point increase in interest rates, and likely further 50 basis point increases in February and March. This is despite signs that inflation is cooling.

The ECB has form: since 2008, the ECB has always been slow and reluctant to stimulate the economy. And the eurozone has grown more slowly than other major economies.

To be sure, it’s not an easy situation. Inflation is high, which is usually a sign the central bank has screwed up. But this is a special case. The war in Ukraine has driven up the price of energy and anything energy-dependent, like food. This variety of inflation is outside the ECB’s control. The debate is over how much of the eurozone’s inflation is coming from outside the eurozone, and indeed whether this matters.

The ambiguity over what, precisely is causing inflation to go up has created an opening for the inflation-hating wing of the ECB. Monetary policy is set by a committee of 30 central bankers and officials. Decisions are always made unanimously.

The macroeconomics are harder than usual . On the one hand, inflation is out of hand and everyone’s pointing the finger at the ECB. On the other, it has to stop the economy from crashing, which could pull the eurozone apart. And the war in Ukraine is making it hard to judge exactly what’s going on. It’s like landing a fighter jet on an aircraft carrier during a storm. 

Now imagine the fighter jet is being steered, not by a pilot, but by a committee of 30 of them. And that there’s no settled opinion on how to fly an aeroplane.

A solid constituency within the ECB hates inflation. The Germans lead this group. For this group, a recession is a price worth paying for keeping inflation under control.

Germans are funny about central banking. In the German imagination, inflation was responsible for the rise of the Nazis, and tight monetary policy was responsible for the success of West Germany after the war.

It’s not a surprise that the German on the ECB’s six-member executive board is the ECB’s chief inflation hawk. Isabel Schnabel has argued the mere expectation of future inflation is so dangerous that it must be crushed right now. She has also argued that the green transition will make the economy weaker in the short run, which will push up inflation. Another justification for raising rates.

Schnabel is from a long line of inflation-disliking German central bankers. Jens Weidmann, the former head of Germany’s central bank the Bundesbank, was always an outspoken critic of Mario Draghi’s loose monetary policy. The ECB’s executive board member from Germany, Sabine Lautenschläger, resigned in September 2020 due to her disagreement with its lax monetary policy. The same is true for Jürgen Stark, a former chief economist from Germany who left the ECB in 2011 due to the ECB’s reaction to the sovereign debt crisis. Before him, the ECB’s loose monetary policies prompted Axel Weber to resign from his position as head of the Bundesbank. 

The German faction is supported mainly by other northern Europeans: Robert Holzmann, Governor of the Central Bank of Austria; Pierre Wunsch, Governor of the Central Bank of Belgium; Madis Muller, Governor of the Central Bank of Estonia; Klaas Knot, Governor of the Central Bank of the Netherlands, Bostjan Vasle, Governor of the Central Bank of Slovenia, and Martin Kazaks, Governor of the Central Bank of Latvia. 

At the other end of the spectrum are Ireland’s Phillip Lane, chief economist of the ECB, Pablo De Cos of Spain, and Fabio Panetta of Italy. They’re from the south and west of Europe. And they’re economists. Economists are more likely to see the consequences of too-tight monetary policy — like the 1930 Great Depression, the 2008 Global Financial Crisis or the 2011 European sovereign debt crisis. 

The case for chill

Before the December meeting, Phillip Lane wrote a blog post on the ECB’s website making the case that the ECB shouldn’t overreact to high headline inflation.

A point he made was that eurozone inflation is still mainly coming from outside the eurozone, ie through imported energy costs. That being true, the ECB should not be raising rates aggressively. Higher rates would raise unemployment without bringing down inflation.

When it comes to inflation in goods, Lane said much of the price rises we’re seeing are due to rising energy costs. Among goods in which energy isn’t a big component, prices are rising at an annual rate of 3.2 per cent, compared to a rate of 6 per cent for all goods. With services, it’s the same story: 2.1 per cent for non-energy intensive services, 4.4 per cent for all services.

The inflation hawks’ big worry is that inflation will become embedded in the economy. Specifically, they’re worried about a wage-price spiral: where people demand higher wages to compensate for higher prices, which in turn puts pressure on prices, and on and on. 

Lane said we’re not in wage-price spiral territory yet. Historic measures of wages, up to the second quarter of this year, show no signs of acceleration. And negotiated wages for the next two years are moderately ahead of the level consistent with the ECB’s mandate. 

Finally, Lane stressed the fact that inflation is expected to fall next year. That’s important because expectations of future inflation are what drive inflation in the here and now.

The following chart from Lane’s post shows a couple of measures of inflation expectations. They all concur that inflation will continue to fall next year, and bottom out at 2 per cent in the second quarter of 2024. 

The ECB’s hawks were unmoved by Lane’s blog post. For them, an unnecessary recession is better than suffering above-target inflation for a while.

This is the way of the ECB. We shouldn’t be surprised it hasn’t changed.