ECB’s Credibility on the Line: Can Interest Rate Hikes Tame Inflation?” – Eamon Quinn Reports

“European Central Bank under fire for lack of scrutiny in tackling current inflation crisis”
ECB's Credibility on the Line: Can Interest Rate Hikes Tame Inflation?" - Eamon Quinn Reports

The European Central Bank (ECB) has been criticized for its handling of the current inflation crisis. Despite being set up to fight hot inflation or deflation, the ECB has received little scrutiny over its management of the crisis. The cost-of-living crisis has been marked by a return of 1970s-style inflation, with the price shocks from the Russian invasion of Ukraine and the pandemic being outside of the ECB’s control.

Since last summer, the ECB has been aggressively hiking rates, with President Christine Lagarde signaling more rate rises to come for households and businesses. However, critics fear that the central bank is in danger of making policy mistakes if it hikes interest rates to too-high levels and keeps them there for too long. They draw parallels between the ECB’s current rhetoric and the dogma displayed during the debt crisis in 2011 when the central bank opted to raise interest rates before being forced to change course.

Senior economists have noted that economists and central banks can understand short-term price pressures from food and energy costs, but are at sea when plotting inflation over a longer term. There is a “dirty little secret” at the heart of economics in that economists and central banks understand less about inflation dynamics than most would like to admit. Economist Austin Hughes says that the ECB has “miserably failed” over 15 years to keep inflation on target and is overplaying the role of interest rates to land soaring inflation where it wants.

Observers have also noted the drifting since last summer in the inflation measure the ECB is targeting. As energy prices cooled, the key rate has become the core or underlying rate of inflation. In her speech in Hanover last week, Ms Lagarde mentioned the inflation word, perhaps not unreasonably, a few dozen times. But signaling more rate rises, she said there was no evidence that underlying inflation had yet peaked. Critics say that such confidence in interest rates to deliver for the ECB and for millions of citizens in the eurozone is misplaced.

Despite these criticisms, futures markets appear to be in lock step with the central bank in betting on rate rises and projecting the ECB will be slower than some counterparts when the time comes to cut rates. The issue of communication usually refers to central banks or governments failing to bring financial markets with them. However, there is little danger of the ECB failing such a test.

New crises bring new tests, and since last July, the ECB has appeared to go back to its orthodox roots displaying a rigor or belief in its inflation targeting. The current inflation crisis is a new challenge for the ECB, and it remains to be seen how effective its policies will be in managing the crisis. With the cost-of-living crisis bearing down on European households and businesses, the ECB’s actions will be closely watched in the coming months.