ECB needs to reset EU’s monetary policy

Inflation in the euro area surged to 8.1% in the year to May, yet again higher than expected. Up to now, despite signs that inflation was getting entrenched, the European Central Bank (ECB) had chosen to stand pat. It had its reasons, but they’re no longer persuasive.
The ECB’s task is difficult, to put it mildly — and only getting more so. European Union leaders said they’re moving towards a partial ban on imports of Russian oil, an essential step in forcing Vladimir Putin’s regime to end its war on Ukraine. But there’s a drawback. New restrictions on energy imports will deliver yet another supply-side shock, keeping Europe’s prices high and adding to the risk of stagflation.
The ECB’s dilemma is much like that of the US Federal Reserve, the Bank of England, and many other central banks: Monetary policy can’t do everything, the damage caused by the pandemic hasn’t abated, and there’s no painless way to respond effectively to Russia’s aggression. Yet, as best they can, central banks have to strike a balance between supporting demand and containing inflation. The ECB is getting this wrong. It’s become an outlier in its approach and needs to rethink.
The Fed and the Bank of England have both raised interest rates and signaled to financial markets that there’s more to come. They abandoned talk of “transitory” inflation months ago — and acknowledged they should’ve changed course earlier. The ECB is still lagging way behind. It hasn’t yet raised its policy rate, which stands at minus 0.5%. Its latest signalling suggests the first increase will be just a quarter of a point — not when its policy makers meet next week, but at the meeting after that, in late July.
With inflation above 8%, a policy rate that’s less than zero in nominal terms maintains an extraordinary, and increasingly reckless, level of extra demand. Too much stimulus applied for too long adds to the danger of a violent correction later. The cost of avoiding a moderate slowdown now might be a deep recession in due course.
To be sure, the ECB has to grapple with bigger problems than does the Fed or the Bank of England. The EU is more heavily dependent on Russian energy, so the supply-side component of its spike in inflation is bigger. Its baseline levels of growth and employment are lower, giving less room for error on the downside. Economic conditions also vary widely across the euro area, along with degrees of tolerance for inflation. (Prices are rising an estimated 5.8% a year in France, 8.7% in Germany, and 20.1% in Estonia.) The right monetary policy in one country won’t fit the case in another.
Likewise, the ECB has to allow for the fact that coordinating fiscal policy across the 19 members of the euro area is hard. Some have chronic public-debt problems, now compounded by pandemic-related spending. This makes higher interest rates more hazardous and their effects harder to judge.
The ECB’s reluctance to remove stimulus is understandable. But the balance of risk has shifted. The surprising new inflation number justifies — and the broader situation demands — a forthright reset. Without further delay, the ECB should start a deliberate effort to normalise policy, beginning with an increase of 50 basis points next week — not next month.

—Bloomberg