Faced with the twin challenges of rising inflation and slowing growth driven by the oil price shock, the European Central Bank is under pressure to act, with Commerzbank AG anticipating the ECB to prioritise long-term inflation expectations and consider an interest rate hike as early as its next meeting at the end of April.
While the surge in inflation necessitates raising policy rates to meet the 2% target, the simultaneous economic slowdown caused by the higher oil price suggests keeping interest rates steady, the German bank said in a report on Tuesday.
The latter effect is expected to naturally curb inflation later on, arguing against an immediate rate hike.
Source: Commerzbank Research
Anchored inflation expectations keep rate hikes at bay
To navigate the challenging environment effectively, the ECB must prioritise the long-term inflation expectations of both citizens and businesses, according to Commerzbank.
These expectations can be gauged by analysing financial market data and conducting surveys.
The ECB will not need to increase its key policy rate if there is a long-term expectation that it will successfully meet its 2% inflation target.
“This is because, with firmly anchored long-term inflation expectations, workers and businesses view the oil-price-driven rise in inflation as temporary,” Jorg Kramer, chief economist at Commerzbank said in the report.
Unions will then not demand massive wage increases, and companies will not attempt to raise their selling prices sharply.
Prompt action required
Should inflation expectations substantially exceed the 2% target, they risk becoming a self-fulfilling prophecy, according to Kramer. For instance, if labor unions anticipate elevated inflation in the near future, their immediate demand for higher wages will, in turn, push inflation upward.
Should long-term inflation expectations rise, the ECB must act swiftly by raising policy rates, according to Kramer.
The move is designed to curb the wage-price spiral by weakening both the economy—which reduces workers’ bargaining power—and the pricing power of businesses.
Instead, Germany tolerates the inevitable decline in profits and income that results from being resource-dependent and having to pay higher energy costs to foreign nations, the report said.
“If the ECB does not raise its rates despite rising long-term inflation expectations, it will have to raise them even more sharply later on,” Kramer added.
The failure to act promptly carries a high cost, as demonstrated by historical events. For instance, the US Federal Reserve was forced to increase its interest rates to nearly 20% in the early 1980s.
This drastic measure was necessary to control the inflation that had severely escalated throughout the preceding decade.
Lessons from the past
While some economists downplay the concerns—noting that the current demand is not fueled by COVID-19 stimulus measures and isn’t constrained by lockdowns, a more favorable starting point than before the war in Ukraine—the public’s memory of the high inflation and loss of purchasing power in 2022 remains a strong opposing factor.
Source: Commerzbank Research
“As a result, companies are likely to quickly raise their selling prices this time around in response to rising energy costs in order to defend their profits,” Commerzbank’s Kramer said.
Surveys of companies point precisely in that direction.
The ECB should focus on long-term inflation expectations and, if in doubt, take action as early as its next meeting at the end of April.
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