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When Central Banks Drive Looking in the Rearview Mirror
How the Fed and the European Central Bank can restore their credibility and anchor inflation expectations
By George Kopits
The surge in inflation on both sides of the Atlantic should not have come as a surprise. The conduct of monetary policy by the Federal Reserve Board (Fed) as well as the European Central Bank (ECB) can be compared to the case of a driver who continuously looks in the rearview mirror. For both the U.S. and the Euro Area, this approach is now likely to lead to a recession. Europe’s road ahead may be even rockier, complicated by the heavy indebtedness of some euro member countries.
Until recently, both central banks seem to have been mesmerized by a lengthy period of price stability, interrupted by supply chain disruptions due to the pandemic and by the commodity price shock from the war in Ukraine. Initially, the jump in prices was interpreted as “transitory,” with no need to taper bond-buying—so-called quantitative easing—or to raise interest rates.
In technical terms, both central banks justified the continued monetary expansion with a shift, in 2020 by the Fed and in 2021 by the ECB, from conventional forecast-based inflation targeting to outcome-based inflation targeting. The latter was essentially a backward-looking average inflation targeting regime that aimed at compensating for past overshoots and undershoots in inflation from the target over several years. In practice, however, average inflation targeting was applied asymmetrically: Only past shortfalls from the target were compensated by allowing overshoots in inflation. Meanwhile, continued reliance on quantitative easing accommodated a sizable pandemic-related fiscal stimulus. Over time, persistent labor shortages and rising inflation expectations have morphed into a price-wage spiral that policymakers can no longer ignore.
Ready for a Strategic Pivot?
By now, as annual headline inflation is running nearly at a double-digit rate in both the U.S. and Europe, exceeding target rates by a wide margin, the drivers of monetary policy must turn their attention to major bumps in the road. Thus, they are compelled to slam on the brakes, which is likely to cause a contraction in output—a prospect that could have been avoided by beginning to slow down earlier. The lagged response to the inflation surge can be characterized metaphorically as a failure to remove the punch bowl “just when the party was really warming up,” as once observed, famously, by Fed chief William McChesney Martin. Now, the belated policy tightening will take at least six quarters to dampen entrenched inflation, if history is any guide.
Inevitably, average inflation targeting had to be abandoned and, without a policy reaction function—that is, a rule to guide the response to economic indicators—central banks have attempted to deploy in an ad hoc manner the speed and extent of monetary tightening while minimizing the collateral damage to economic activity. However, instead of the current discretionary, “meeting-by-meeting” approach—just announced by Fed Chairman Powell and ECB President Lagarde—both major central banks should consider rapidly converging to a viable monetary rule.
One option would be the well-known Taylor rule to set the policy interest rate as a function of the excess of forecast inflation over the target and of the output gap. An alternative rule, in principle superior in several respects—albeit not known to have been implemented anywhere—consists of nominal GDP targeting, long advocated by some economists. Unequivocal adoption of a forward-looking, rule-based framework would anchor inflation expectations and help the monetary authorities restore their own credibility.
ECB at the Crossroads
The task faced by the ECB is far more complex, and the risk of insufficient response to inflationary pressures seems greater, than in the case of the Fed. Inflation has accelerated faster in Europe than in the U.S., partly due to the proximity of the Ukrainian conflict and to the depreciation to parity of the euro against the dollar. Moreover, any attempt to rein it in through interest rate hikes is inhibited by those hikes’ impact on the interest rate spreads on bonds issued by highly indebted euro governments. Contrary to President Lagarde’s declaration at the start of the pandemic that “we are not here to close spreads,” currently the ECB seems to be frantically agonizing over how to do precisely that. The upshot is that the dual objective of containing inflationary pressures and narrowing interest rate spreads may further undermine the credibility of the ECB.
Any attempt to cap spreads on Italian, Spanish or Greek bonds through the newly unveiled Transmission Protection Instrument is questionable on several grounds. A similar Fed rescue facility for bonds issued by high-debt U.S. states, such as California or Illinois, would be regarded as an unacceptable violation of an implicit no-bailout principle. It is worth recalling that in the euro area, such a policy would be equally inconsistent in spirit, if not in the letter, with the no-bailout clause enshrined in the European Union’s Maastricht Treaty.
Perhaps more important, the confluence of anti-fragmentation measures with the present suspension of the fiscal rules under the EU’s Stability and Growth Pact is likely to create moral hazard. Highly indebted governments facing domestic political pressures may be tempted to forgo or postpone necessary tax hikes or spending cuts. Indeed, ECB efforts to narrow spreads are tantamount to free-of-charge insurance to reduce the risk premium on their bonds. If triggered, this subsidy would prolong the dysfunctional use of monetary policy as a fiscal instrument.
Instead of providing mostly symptomatic relief through the Transmission Protection Instrument on a discretionary basis—somehow piggybacked on the enforcement of each country’s pandemic Recovery and Resilience Plan (RRP)—the ECB should consider extending any assistance on explicit and transparent terms, including effective conditionality that seeks to address the indebtedness at the root of the spreads. There is no obvious reason why the ECB could not invoke the existing Outright Monetary Transactions facility, unveiled in 2012 but never triggered. This provision involves conditionality, under the “whatever it takes to save the euro” slogan, which, when announced, had a soothing effect on spreads. In addition, the European Stability Mechanism is a financial institution well equipped to design, finance and monitor appropriate adjustment programs for eligible euro member countries in financial distress.
The combination of rising interest cost with Italy’s public indebtedness is pushing the country toward a possible crisis. General government liabilities total some 150% of GDP, plus another nearly 50 percentage points for the net present value of Italy’s future pension and healthcare liabilities, by International Monetary Fund estimates. This debt level is bound to become unsustainable because the liabilities are denominated in a currency that Rome cannot devalue, as euro liabilities are beyond the control of national authorities. To cope with such a predicament, leaders of major political parties last year formed a broad-based coalition government, whose major achievement has been to secure the largest EU support under the RRP among all member countries.
Disbursement of the RRP grants and loans is contingent on the phased implementation of critical pro-growth structural reforms, which in Italy include wide-ranging deregulation, taxation and public administration. But commitments in these areas have gone unfulfilled, as declining support from three major political parties resulted in the collapse of the coalition government and a call for new parliamentary elections.
Given the uncertainty regarding the outcome of the elections and the likely formation of a coalition including anti-establishment parties, Italy may become vulnerable to a multiple-equilibrium crisis: Imagine a Greek-style debt trap on a much larger scale. In other words, an unexpected event, such as the new government’s refusal to reaffirm commitments under the RRP, may precipitate a sudden shift from the current “good” equilibrium to a “bad” equilibrium. This involves not merely a further jump in risk premium on bonds but loss of access to financial markets.
In a more favorable scenario, the next government in Rome may be willing to muddle through with promises of watered-down measures—reluctantly endorsed by key interest groups—which EU authorities might accept for the sake of saving the euro. Such a scenario would provide some palliative care for a limited time, but ultimately it would not prevent a further erosion of trust in the Italian political leadership as well as in the EU’s institutional framework.
Although the case of Italy is of limited relevance for Europe as a whole or for the U.S., it can be regarded as a cautionary tale for politicians and policymakers who currently are facing simultaneous challenges in curbing entrenched inflation and in containing a further rise in public debt. On the monetary front, it is time to phase in a sound forward-looking rule. On the fiscal front, well-targeted structural reforms are essential. In all, such steps would ensure economic stability and sustained growth.