Now, ECB ain’t a bank that does inflation-targeting

Central banks have scarcely covered themselves in glory these past few years. Most have one goal and one goal only: to keep inflation low. In most countries, they have spectacularly failed at this job. In much of the developed world, inflation has reached many multi-year highs. I can’t think of a central bank whose record has been as lamentable as the European Central Bank (ECB). At least its Turkish counterpart has the excuse of being under the thumb of Recep Erdogan, the country’s president, whose contributions to economics are on a par with Vladimir Putin’s to international diplomacy.
The ECB has now put itself in an impossible position. Only in the statutes is the ECB’s main goal to keep inflation close to but under 2%. For the past 10 years, rather than targeting inflation, monetary policy has been set with a view to keeping its weakest members from leaving the currency union. Bluntly, it is no longer an inflation-targeting central bank.
That fact has become ever more obvious with every month that passes. At last count, overall euro zone inflation is at a record high 8.1%, but those records only go back to 1999. At 8.7%, Germany’s inflation rate is far higher now than it was at any time in the 1970s. Only in the minds of the ECB would it be anything other than insane to have left its key interest rate unchanged at minus 0.5% throughout this inflationary surge.
It didn’t do anything to rates at this week’s meeting either. But it has, at least, now admitted that inflation is broadening as well as accelerating, which had long been obvious to anyone that wasn’t the ECB. Core inflation, stripping out energy and food, was 3.8% at last count. Services inflation was 3.5%. And the ECB promised, under huge pressure from northern Europe in recent months, to lift them by half a percentage point, perhaps more, over the next couple of meetings and, at the beginning of July, stop adding to its gargantuan bond portfolio, now some 9.3 trillion euros ($9.77 trillion), or 70% of euro zone gross domestic product. Cheap lending to banks, via targeted longer-term refinancing operations, or TLTRO, will mostly end on June 23. The ECB won’t, however, shrink its balance sheet.
All this now apparently passes as hawkish for the ECB. It isn’t, and nothing the ECB has announced will have the slightest effect on inflationary pressures.
Given how little it has promised to do and how late it is in dealing with inflation, its forecasts look ridiculous, unless the inflation rate spontaneously falls. The ECB expects inflation to average 6.8% this year, 3.5% next year and 2.1% in 2024.
To burnish the ECB’s inflation-busting credentials, its president, Christine
Lagarde, preempted last week’s pre-commitment, as it were, by writing in a blog that the central bank would take “whatever steps are needed” to reach its 2% goal. The parallels with Mario Draghi’s infamous off-the-cuff “whatever it takes” comment, which calmed the euro crisis 10 years ago, are clearly deliberate. But Lagarde is no Draghi, and this statement looks very odd. Everything the ECB does must, by law, be subservient to this goal in any case. The only way to interpret the need for such comments is that at every turn since Draghi’s remarks, the ECB has always and mainly favored supporting weaker members of the euro zone by keeping short-term rates as low as it can and compressing yields and spreads over German debt.
The ECB could disguise its true intentions when inflation was low but when inflation is high and rising, disguising its true aims becomes impossible. Ignore the gnomic comments from Lagarde about “new tools” for dealing with this problem; the ECB can’t target inflation and keep spreads of weaker peripheral borrowers, such as Italy, low. This is why yields for peripheral borrowers have been rising even more sharply than yields of core-country debt. Anyone unlucky enough to have bought a zero-coupon 30-year Italian bond at the peak last year would now have lost about half their money in nominal terms and a lot more in real terms. If the ECB is serious about tackling inflation, spreads will continue to blow out.
Although I have deep reservations about inflation targeting, trying to subsidize weaker borrowers is an even worse policy. The ECB should have nothing to do with it. By extinguishing market signals, all that the ECB has succeeded in doing is to create the mother of
all moral-hazard problems.
Debt-to-GDP ratios for weaker borrowers — France included — have ballooned since the global financial crisis.
Yes, some of this was growth because of government pandemic spending, but most of the growth predated Covid. It is completely untenable to say that ECB policy wasn’t a major factor. Ultimately, it should not be for the ECB to decide who is and isn’t in the euro. The rules for being in the euro are not secret. While they are rather silly and clunky in many respects, you can’t have a euro without rules, given how different the countries in it are and
the manifest problems of weaker borrowers free-riding off stronger ones.
Yes, doing something about deficits and debt ratios is painful. But not doing anything about them when inflation is high and rates are rising is also painful. Italian 10-year yields are more than five times what they were in mid-2021. As I said at the beginning January, this is likely to be a make-or-break year for the euro.

—Bloomberg

Richard Cookson was head of research and fund manager at Rubicon Fund Management. Previously, he was chief investment officer at Citi Private Bank and head of asset-allocation research at HSBC