Next Thursday, the 25 members of the European Central Bank’s governing council will come together at the bank’s head office in Frankfurt. The group meets once every six weeks to set interest rates and tinker with monetary policy for the 19-nation euro currency bloc.
As ever, one topic will be at the top of the agenda: Inflation.
Only this time, for the first time in four years, the central bank has actually surpassed its own goal: According to initial estimates, consumer prices rose by 2 percent year-over-year in the euro zone in February, as reported by Eurostat, the statistics office for the European Union, on Thursday. It’s the biggest annual inflation since January 2013, and above the ECB’s self-proclaimed target of keeping price increases at “close to but below” 2 percent.
This significant price hike is once again fueling a debate about the ECB’s monetary policy – above all in Germany.
Until now, the ECB has justified its ultra-lax monetary policy of the past few years – which has included pumping more than €1 trillion into the economy through a bond-buying program – by pointing out that it was missing its inflation target and by highlighting fears of crippling deflation.
That argument is no longer valid. The ECB has now met its target. It’s a major development in the eyes of German officials and households: “Higher inflation rates withdraw the basis for the ECB’s policy of cheap money,” said Ralph Brinkhaus, deputy chairman of the Christian Democratic Union parliamentary group in the Bundestag, Germany’s lower house of parliament.
“A zero interest-rate policy when inflation is rising will be disastrous for German savers.”
Rising prices can be extremely dangerous if they spiral out of control, something Germany knows all too well. Many here keep alive the historical tales of a bout of hyper-inflation that struck the German economy in the early part of the last century – a lesson that influences many of the the country’s politicians and economists to this very day.
Germany’s conservative economic circles – which dominate much of the political thinking here but are by no means the only school of thought – have been making themselves heard over the past few months. Rising inflation in Germany has already had a serious impact on German banks and household savings. For many here, it’s also a matter of the ECB’s credibility.
“If inflation starts to rise again now, the ECB must be consistent and raise interest rates,” said Carsten Linnemann, who heads an association for small and medium-sized enterprises in the CDU party.
Markus Söder, the conservative finance minister for Bavaria, put it even more plainly: “A zero interest rate policy when inflation is rising will be disastrous for German savers.”
To date, the ECB has paid little heed to the German warnings. ECB President Mario Draghi has long maintained that his job is to watch over the entire euro zone and famously urged “patience” from Germans at the start of this year.
The ECB’s governing council decided in December to extend the bank’s controversial bond buying program, which has now been running for two years, until the end of 2017. From April, however, the volume of bonds purchased each month will be reduced slightly, from €80 billion ($84 billion) to €60 billion.
Jens Weidmann, president of the Bundesbank, the central bank of Germany, has been a sharp critic of the policy and voted against the December decision. Now, Mr. Weidmann thinks that inflation in the euro zone could be much higher than the ECB previously forecast for this year, owing to a sharp rise in oil prices.
“Inflation is likely to be significantly higher than previous forecasts this year,” he said recently.
Mr. Weidmann expects the forecast for prices in Germany, which hit 2.2 percent in February, to be revised upwards by about half a percentage point for this year. The Bundesbank in December predicted inflation in Germany at an annual rate of 1.4 percent on average for this year. The ECB’s governing council will also present new inflation forecasts for the entire euro zone at a meeting next Thursday. Mr. Weidmann’s comments suggest that these, too, could be higher than previous forecasts.
Until now, Mr. Draghi has shrugged off the concerns by attributing rising inflation mainly to one-off effects, caused by surging oil prices. At the beginning of 2016, the price of oil dropped to below $30 per barrel. Now it is around $55, a substantial increase on last year’s low figure. Oil prices began to rise in March 2016, however, which means that the base effect will soon subside. The ECB and other economists expect annual inflation could fall again in the coming months as a result.
The biggest driver of inflation in February was indeed the higher oil prices. Energy costs rose by 9.2 percent in February, while the cost of services, for example, increased just 1.3 percent.
Food prices are also thought to be particularly volatile, and are being affected by poor weather conditions in some southern European countries. Consumers had to pay 2.5 percent more for food, alcohol and tobacco than in the corresponding month of last year.
Given the one-off effects, Germany’s more liberal wing is still willing to give Mr. Draghi the benefit of the doubt.
“The increase in inflation that is currently being observed in the euro zone is due in particular to extraordinary factors in the areas of energy and food,” said Gerhard Schick, the financial policy spokesperson for Germany’s Green Party.
For this reason, he was doubtful about whether the inflation rise was really sustainable. Eurostat’s measure of “core inflation,” which excludes the volatile food and energy prices, rose just 0.9 percent in February. A more sustainable rise would be a requirement for the ECB to normalize its monetary policy, Mr. Schick said.
“Only if we have certainty here and if economic growth continues should the ECB raise interest rates.”
The biggest question, then, is just how much of those “extraordinary effects” will carry through to other prices. Even if energy prices do not directly influence core inflation, they can have an indirect impact, for example when they affect transport costs or the price of package holidays.
The ECB will need to keep an eye on whether the inflation rate stays at 2 percent or above for a longer period,” said Lothar Binding, financial policy spokesperson for the center-left Social Democratic Party. “Only if we have certainty here and if economic growth continues should the ECB raise interest rates.”
Most members of the ECB’s governing council are likely to be thinking the same thing. With inflation having dropped lower and lower for almost five years, many people want to wait and see whether it will actually stabilize at its current level.
The core inflation rate, which is adjusted for volatile prices, is regarded as the key indicator of price trends over the medium term. The ECB points to the fact that its level has barely changed since the central bank began its bond purchasing program two years ago.
Critics, led by Germany, point out that monetary policy takes time to have an effect, and that makes it necessary to take action early rather than waiting for prices to hit the 2 percent mark consistently. By then, you risk overshooting your target.
Besides the debate over the inflation numbers, there is another component. Peter Praet, chief economist at the ECB, recently made it clear that monetary authorities should take political risks into account.
Elections will soon be held in the Netherlands, France and possibly Italy. In view of the possible rise of the far right in the Netherlands and France, the ECB is concerned about “political accidents,” Mr. Praet said.
Investors are also worried that populist forces could register gains in these countries. These fears have already caused the interest-rate gap between German government bonds and the state debt of some other euro-zone countries to widen significantly. If the ECB tightens its monetary policy, this could cause the gap to become even wider.
Mr. Praet also sharply criticized threats by U.S. President Donald Trump to charge high tariffs on imported goods from low-wage countries. His comments suggest that, despite the higher inflation, there are no signs at present of a quick change of course in monetary policy.
Critics of the ECB’s policy, such as Mr. Brinkhaus of the Christian Democrats, are demanding that the central bank at least give a clear signal that a turnaround could be coming. An abrupt change in monetary policy down the line, without communicating it first, could have serious economic consequences.
“The ECB should therefore prepare now for the beginning of the end, and should communicate this clearly,” Mr. Brinkhaus said.
Jan Hildebrand is Handelsblatt’s lead political correspondent in Berlin, Frank Drost covers financial regulation from Berlin and Jan Mallien covers monetary policy and the ECB from Frankfurt. Christopher Cermak of Handelsblatt Global contributed to this piece. To contact the authors: Hildebrand@handelsblatt.com, email@example.com and firstname.lastname@example.org