Progress in vaccination campaigns and a recovery in the global economy have significantly improved the macroeconomic development in the euro zone countries in recent months. In this environment, the European Central Bank (ECB) has raised its projections for consumer price inflation and gross domestic product growth this year and next. However, as the central bank expects inflation rates to return to well below its target soon, it is maintaining its expansionary monetary policy stance. The revised strategy does not change this intention. The bank does not yet see the time as having come for exit debates and a tightening of policy. However, in view of favorable growth prospects and rising inflationary pressures, this question will arise with greater vehemence as the year progresses. Cautious corrections of monetary policy appear appropriate.
According to the ECB, the higher price level increase in recent months is mainly due to temporary effects. The bank has increased its inflation projections for this year and also for 2022, but still sees a rate of change in consumer prices in the euro zone of only 1.5% in the coming year, which is below its target value. However, even the ECB’s somewhat higher projections must be regarded as very moderate.
While the inflation rate in the EMU is at a much lower level than in the USA, the price-driving mechanisms are the same: energy price increases and broad-based increases in raw material prices, supply bottlenecks for intermediate products, high transport costs (container freight rates) and strong increases in demand, especially for services, will keep inflation rates at a high level for consumers and probably push them above 3% in the second half of the year.
Over time, bottlenecks and supply constraints will be overcome and the price-driving pent-up demand for services will also subside. However, given the large amount of additional money saved in the euro area in the wake of the Corona pandemic, much of which is likely to be used for pent-up consumption, aggregate demand should remain quite strong well into 2022. Moreover, it depends to a very large extent on future wage increases whether inflation rates will soon fall below the 2% target again. In view of significant losses in purchasing power for wage earners, sharply rising corporate profits and a shortage of labor in many areas, rising wage settlements should be expected.
The ECB has so far given no indication of possible corrections of its expansionary policy stance, and it is continuing its bond purchases under the PEPP program (Pandemic Emergency Purchasing Program) unabated. It argues that the time has not yet come to discuss an exit from extremely loose monetary policies. Rather, it underlines the importance of securing favorable monetary conditions. For financial market participants, this is a kind of assurance that the ECB would oppose significantly rising yields on government bonds and deteriorating financing conditions for companies. Therefore, in the wake of a strong economic recovery, the odds are in favor of further rising valuations of equities and real estate despite the high level they have already reached.
However, the arguments for reducing monetary policy stimulus will arise with greater vehemence in the coming months, particularly with regard to a scaling back of the large-scale bond-buying programs. After all, if monetary conditions remain too loose for too long, there is a risk not only of undesirably high inflation expectations but also of increasing exaggerations on the financial markets, which pose a threat to medium-term growth. This risk is regularly pointed out by the International Monetary Fund in its analyses. It is all the bigger, the more the exuberance on financial markets is accompanied by strong credit growth in the private sector. One only has to recall the extreme cases of the past two decades, the dotcom bubble at the beginning of the millennium or the subprime crisis 13 years ago, which showed how great the losses in growth and prosperity can be when blatant excesses on the financial markets are corrected. For monetary policy, therefore, it can be important to lean against the wind in the face of financial market euphoria and not rely on bank regulation alone to preserve financial stability. In the current situation, once again, there is something to be said for this strategy: very strongly rising (real) real estate prices, high stock market valuations, extremely low-risk premia in many financial market segments and the surge in the amount of money in circulation in the private sector argue in favor of at least somewhat reducing the degree of monetary policy stimulus and not completely preventing market-driven increases in capital market returns. This may dampen the economic and financial market cycle in the short term but will bring higher and steadier growth in the medium term.
The review of the ECB’s monetary policy strategy does not seem to herald major changes to its practical policies. The analysis of monetary and financial developments will no longer be analyzed in a second pillar (next to inflation), but in an integrated manner. The statements by the ECB give no indication however that changes in money supply and credit growth, for example, will become more important as a systemic factor in policy decisions. Moreover, the reformulation of the inflation objective, asymmetrical 2 percent target, can be seen as a reconfirmation of the ECBs present stance of very high policy accommodation.
To sum up, monetary policy is always an act of balancing opportunities and risks. At present, the ECB apparently considers the opportunities of a continued expansionary policy to be greater than the risks and side effects that may result in terms of higher inflation and further risks on financial markets. However, the debate about reducing monetary stimulus, which is well underway in U.S.A., will not be long in coming in the euro area either. Here, too, the first step is likely to be a scaling back of the large-scale bond-buying programs. That may provoke criticism and possibly adverse market reactions. In the interest of stable economic and financial market development in the medium term, it should nevertheless take place.