Monetary policy in times of geopolitical crises and
high inflation
Speech at European School of Management and Technology (ESMT)
30.08.2022 | Berlin | Joachim Nagel
1 Introduction
2 Why has inflation gone up?
3 Are we heading for stagflation?
4 How should monetary policy respond?
5 Concluding remarks
1 Introduction
Ladies and gentlemen,
The topic of money is one we hear cropping up in popular music again and again,
often accompanied by a critical undertone. I'll give you three examples. Liza Minnelli
sang "money makes the world go around". Pink Floyd incorporated the sound of a
cash register into their song "Money". And then of course there's ABBA, with the
lyrics "money, money, money, must be funny, in the rich man's world".
What links the three tracks is the period they emerged from: all three were
composed and hit it big in the 1970s. And it's probably no wonder. After all, that
was a time when the purchasing power of money took a major tumble. And people
were feeling what it meant not to have a stable currency.
The bands Pink Floyd and ABBA were at the peak of their careers in the 1970s. And
both bands have recently reappeared on the scene:
Just over four months ago, Pink Floyd released a new single to offer support to
Ukraine as it defends itself against Russia's war of aggression.
After an almost 40-year hiatus, ABBA brought out a new album last November. In
the first week after its release, it sold more copies in Germany than the rest of the
top 100 combined. A hologram tour went on the road three months ago, with
ABBA appearing as digital avatars on stage.
Is the persistent inflation of the 1970s also making a comeback?
Inflation in Germany, as measured by the Harmonised Index of Consumer Prices
(HICP), is above the 8% mark for what is now a fourth consecutive month. The last
time inflation rates hit similar levels in Germany was just under half a century ago -
during the first oil crisis. And this is prompting many observers to draw parallels with
the inflation of the 1970s.
In my speech today, I would first like to shed light on the background to the current
wave of price increases. I will then turn to the question of whether there really are
parallels to be drawn with the Great Inflation of the 1970s. I will finish by
considering what the Eurosystem can and must do to tame the high inflation and
secure an inflation rate of 2% over the medium term.
2 Why has inflation gone up?
Let us first look at what's behind the current inflation dynamics. This afternoon, the
Federal Statistical Office published provisional inflation figures for August. They
estimate that inflation in Germany, as measured by the
HICP (Harmonised Index of Consumer Prices), is currently at 8.8%. Inflation in the
euro area as a whole has been running well above the Eurosystem's 2% target for
quite some time now.
Many view Russia's war against Ukraine and its economic repercussions as key
factors behind the high inflation. And indeed, the war has caused a huge surge in
prices, above all for energy, thereby significantly stoking price dynamics in general.
But that is not the only reason for the high levels of inflation, not by a long way.
Even before the outbreak of the war, price pressures had intensified considerably.
For example, the rate of inflation in Germany, as measured by the
HICP (Harmonised Index of Consumer Prices), had already been sitting above 4%
since September 2021. On an annual average, the
HICP (Harmonised Index of Consumer Prices) rate stood at 3.2% in 2021. In
February 2022, it had already reached 5.5%.
One major factor driving this momentum was the global economy's unexpectedly
swift recovery from the pandemic-induced recession. The fiscal and monetary policy
support measures taken around the globe to limit the economic damage caused by
the pandemic played a part in this. The rapid revival of economic activity then sent
commodity prices soaring.
Another contributing factor was the shift in consumer demand away from services
and towards goods during the pandemic - instead of heading to the cinema or the
gym, people were ordering laptops and exercise bikes. That left industry struggling
to produce enough to keep up in some cases. This has further exacerbated price
inflation, both for final products and at upstream stages.
In addition, the pandemic disrupted global supply chains and transport routes. Some
of these supply disruptions have proved to be more persistent than initially
expected. This, too, has had a hand in pushing up prices. And, with demand robust,
energy prices were already on the rise before the war began.
3 Are we heading for stagflation?
The question that now arises is: how long will the current period of high inflation
rates last? According to our latest forecasts, we are expecting the strong inflation to
return to normal in the medium term. Uncertainty, however, is exceedingly high.
Many already see us facing a repeat of the stagflation of the 1970s. The word
stagflation is a portmanteau of stagnation and inflation, coined to reflect a
contemporary combination of high inflation rates and stagnating economic output.
Are we once again facing years of high inflation and weak growth? There are indeed
some parallels between stagflation at that time and the situation today.
During the 1970s, the two oil crises in 1973 and 1979-80 sent inflation soaring. In
the present day, the pandemic-related supply constraints and the Russian attack on
Ukraine are having a similar impact on prices.
Current oil price increases are significantly lower than they were back then. This time
around, though, oil is not the only factor, as gas in particular is playing a critical role
as well. The price of gas in the German market was almost five times as high in July
as it was a year ago. By comparison, Brent crude oil was "only" 70% more
expensive in euro.
And the worst may be yet to come. A persistent limitation in gas supplies would,
amongst other things, prolong the period of high inflation rates and increase the
risk of second-round price increases becoming entrenched. [1]
The stagflation of the 1970s and developments today also share similarities in the
expansionary orientation of fiscal policy. To wit, many countries have cushioned the
pandemic-related economic slump by rolling out large-scale fiscal support measures.
In the 1970s, the fiscal policy response in industrial countries to the first oil crisis
was also accommodative, with the aim of shoring up purchasing power. [2] Germany
saw strong wage growth, especially in the public sector. In addition, the fiscal
situation in the United States was already strained in the run-up to the oil crisis
owing to the high level of spending on the Vietnam War.
That said, there is some evidence that today's crises will have a different impact on
economic activity, perhaps even a lesser one.
Thus, the degree of fiscal policy accommodation is still high, but it is declining
overall. This is because the pandemic has largely been overcome and coronavirus
response measures are being phased out.
Moreover, there are structural differences between the labour markets in the 1970s
and today. The indexation of wages, which was very widespread back then in the
United States and parts of Europe and which fostered wage-price spirals, barely
exists anymore. This means that the probability of a wage-price spiral emerging
today is also lower than it was at that time.
The next important difference is in inflation expectations.
Signs of a change in longer-term inflation expectations - known as unanchoring or
de-anchoring - were already evident in the United States before the first oil price
shock. [3] In hindsight, the oil price shocks at that time were arguably no more than
a catalyst for consumer price inflation that was already in progress.
At present, longer-term inflation expectations in the euro area, especially those of
professional market participants, appear to still be anchored.
But at what point do we actually start talking about unanchored inflation
expectations? Certainly not when short-term expectations exceed the central bank's
inflation target because of temporary fluctuations in inflation. But definitely once the
point is reached at which longer-term inflation expectations also begin to move
away from the target.
The question of inflation expectations brings us to the next - and certainly also the
central - aspect when comparing the stagflation of the 1970s with current
developments: the institutional framework in which central banks operate.
In the early 1970s, the US (United States) Federal Reserve was effectively not
independent and faced major political pressure to support the maximum
employment objective. [4] As a result, inflation expectations rose hand in hand with
inflation over the course of the 1970s.
In addition, the oil crisis in 1973 occurred shortly after the collapse of the Bretton
Woods system of fixed exchange rates. Monetary policy was no longer geared to
the exchange rate. At the time, monetary policy objectives and instruments were
not yet clearly defined in many countries.
This is in stark contrast to the situation today. Most central banks are now
independent and clearly focused on combating inflation.
The Federal Reserve's dual mandate also does not currently restrict its efforts to
combat inflation. In fact, it was above all also the situation in the US (United States)
labour market, where there were multiple job openings for every one unemployed
person and a commensurate considerable increase in wage growth, that moved
US (United States) monetary policy to adopt a significantly more restrictive stance.
4 How should monetary policy respond?
Viewed from this perspective, the institutional conditions for anchoring inflation
expectations are arguably better overall today than they were back then.
This should not lead us into complacency, though. Inflation rates will not return to
the central bank's inflation target of their own accord. Monetary policy needs to
respond decisively in order to preserve the credibility of the inflation target.
If this doesn't (Tonne) happen, firms, households and wage bargainers may well lose
faith in the medium-term inflation target.
One warning sign here is the fact that longer-term inflation expectations are now
showing a stronger response to surprises in the inflation rate. There are other signs,
too, that the risk of inflation expectations becoming unanchored has increased.
Against this backdrop, it is clear that European monetary policymakers need to take
action - and they are taking action: a decision was made in June for the Eurosystem
to discontinue net asset purchases under the long-running asset purchase
programme (APP (Asset Purchase Programme)). And last month saw us decide to
raise the key ECB (European Central Bank) interest rates in the euro area for the first
time in 11 years.
An interest rate move of 25 basis points had been announced. But at its July
monetary policy meeting, the ECB (European Central Bank) Governing Council
judged that it was appropriate to increase the key ECB (European Central Bank)
interest rates by 50 basis points. The era of negative interest rates is therefore over.
What is more, the Governing Council assumes that further normalisation of interest
rates will be appropriate. How far we raise interest rates, and by what increments,
depends on how the assessment of the inflation outlook evolves.
I supported the outcome of the meeting. As I see it, a larger interest rate increment
reduces the risk of inflation expectations becoming unanchored. Moreover, it lowers
the risk of us having to increase interest rates too drastically at a later stage. We also
should not delay further interest rate moves out of fear of a possible recession.
Empirical findings support this approach. Based on these findings, data from a
number of countries show that "frontloading", that is, bringing forward interest rate
moves, lowers the risk of the economy suffering a hard landing. [5]
And, overall, it can be said that the longer inflation remains high, the greater the risk
of inflation dynamics, as well as inflation expectations, becoming entrenched at a
high level in the medium term.
Given persistently high inflation rates, the effectiveness of monetary policy measures
could decline. For instance, this is then the case if, amongst other things, firms
change their price-setting behaviour.
In an environment of persistently high inflation rates, business owners pay
comparatively less attention to current demand and more to expected future
inflation when it comes to setting prices. Taken in isolation, this can reduce the
effectiveness of conventional interest rate moves, as the central bank mainly
influences demand by means of changes in interest rates.
In order to nonetheless tame inflation, the central bank therefore needs to act more
decisively when tackling persistently high inflation - in other words, it needs to
respond more strongly to a deviation of the inflation rate from its target.
Given the substantial uncertainty, it is not yet possible, in my view, to say how high
the key ECB (European Central Bank) interest rates will increase.
What is clear, though, is that if inflation becomes entrenched at a high level, there is
ultimately a greater risk of a monetary policy response that would have sufficed in
an environment of low inflation rates now no longer being enough to ensure that
inflation expectations remain firmly anchored. And, as I explained earlier,
unanchored inflation expectations stand out as one of the root causes of the Great
Inflation in the United States in the 1970s.
Back then, the Fed (Federal Reserve System) - in the face of persistently high
inflation rates in particular - for a long time failed to tighten its monetary policy
aggressively enough to anchor inflation expectations and stabilise price
developments.
It was only Fed (Federal Reserve System) Chair Paul Volcker who managed to cut the
Gordian knot of inflation. He did so by allowing short-term interest rates to rise to
almost 20% at the beginning of the 1980s. However, this came at a high price: the
US (United States) economy slipped into two recessions in quick succession.
To prevent an unanchoring of inflation expectations, the Eurosystem should
therefore not allow any doubts whatsoever to emerge in the first place over its
determination to combat inflation. Central banks could repeat the mistakes the
Fed (Federal Reserve System) made in the 1970s, above all in a situation where their
response to inflation pressures is too little, too late.
5 Concluding remarks
Ladies and gentlemen,
In 2004, Paul Volcker, the "slayer" of inflation in the 1970s and beyond, was asked
what he considered to be the most important legacy of the Great Inflation. He
answered: "Don't (Tonne) let inflation get ingrained. Once that happens, there's too
much agony in stopping the momentum. That's the lesson of central banking all
over the world". [6]
Well, I am doing everything within my power to ensure that we, the Eurosystem, live
up to this legacy.
I wish to thank you for your attention and now look forward to stimulating
discussions.
Footnotes:
1. Deutsche Bundesbank, Outlook for the German economy for 2022 to 2024,
Monthly Report, June 2022, pp. (pages) 35-41.
2. Black, S. (Seite) (1985), Learning from adversity: policy responses to two oil
shocks, Essays in International Finance, No 160.
3. Reis, R. (2021), Losing the Inflation Anchor, Brookings Papers on Economic
Activity, BPEA Conference Drafts.
4. Weise, C. L. (2012), Political Pressures on Monetary Policy during the
US (United States) Great Inflation, American Economic Journal: Macroeconomics,
Vol. (Volume) 4(2), pp. (pages) 33-64.
5. Boissay, F., F. De Fiore, and E. Kharroubi (2022), Hard or soft landing?,
BIS (Bank of International Settlement) Bulletin No 59.
6. Samuelson, P. J., The Fed (Federal Reserve System)'s inflation machine: What
would Volcker do?, The Washington Times, 19 October 2021.