ECB shouldn’t obsess about inflation

Just because something is unlikely doesn’t mean it’s not worth worrying about it. A sudden return of inflation after years of weak price pressures fits right into this category.
The euro zone is particularly exposed to a sudden return of inflation. The European Central Bank’s (ECB) loose monetary policy has played an essential role in preserving financial stability in the single currency area. The ECB must be very clear that it is ready to tolerate a temporary acceleration in price pressures — however unlikely that might seem now. The alternative is to risk a repeat of the sovereign debt crisis that marred the monetary union in the early 2010s.
In many ways, it seems rather absurd to fret about inflation. The euro zone’s harmonised index of consumer prices stood at -0.3% in December, which is much lower than the ECB’s target of “below but close to” 2%. The pandemic has pushed the region into a painful recession. Successful mass vaccination campaigns will help the economy to return to normal, but it will take years to make up the lost ground. As a result, wage pressures are likely to remain subdued, bringing little real threat of sustained inflationary pressures.
There is, however, a different scenario that some investors are starting to consider. It focuses on how the pandemic has hobbled many economies’ productive capacity as falling demand and lockdown restrictions forced some businesses to close shop. Yet at the same time, a sizeable proportion of the population has seen its savings increase sharply as people preserved their income but had little occasion to spend it.
Were normality to return abruptly, the combination of supply constraints and pent-up demand and could spark a sudden increase in prices. Businesses would embrace that as they seek to rebuild profit margins. Last week, a key gauge of market-based inflation expectations in the euro area jumped to the highest level in almost a year, matching a similar trend in the US. Right now the European Central Bank is pursuing an aggressive monetary policy to stave off the risk of deflation. This is unquestionably the right approach, since the central bank’s own forecasts show inflation will remain below its target as far as 2023.
If anything, there was a case for even greater stimulus when the ECB last met in December. Then President Christine Lagarde sought to broker a compromise between the governing council’s different factions, but result fell short of her own dire warnings.
In theory, the ECB should be delighted about the prospect of greater price pressures. After all, this is
exactly what its policy is
pursuing.

—Bloomberg