As I predicted back on March 22nd, on April 11th, the European Central Bank’s Governing Council decided to keep its policy-setting interest rates unchanged, with the key deposit facility at 4%. Here is how they motivate the decision:
The incoming information has broadly confirmed the Governing Council’s previous assessment of the medium-term inflation outlook. Inflation has continued to fall, led by lower food and goods price inflation.
They also see an overall “easing” of so-called underlying inflation trends, i.e., in variables that are considered important in determining future inflation rates.
Even though they do not comment on it, this no-change decision was not an easy one to make. The ECB is walking a fine line between securing a return of inflation to 2%—the long-term goal it shares with other central banks—and helping ease the recession that is now spreading through the euro zone. So far, the ECB puts more emphasis on the inflation target and has no immediate plans to change that:
The Governing Council’s future decisions will ensure that its policy rates will stay sufficiently restrictive for as long as necessary. If the Governing Council’s updated assessment of the inflation outlook … were to further increase its confidence that inflation is converging to the target in a sustained manner, it would be appropriate to reduce the current level of monetary policy restriction.
Back in March, I noted that there is at best a 50% chance that the ECB will cut rates at its meeting in June. I motivated this primarily with the fact that the ECB’s interest rate decisions for the most part follow the decisions made by the Federal Reserve. This policymaking correlation is strong, but there is of course also a degree of independence in how the Europeans conduct their monetary policy.
The question is how they use that window. The ECB headquarters in Frankfurt, Germany is filled with expertise in economics, but I am not at all confident that—to be blunt—they know what they are doing over there. When they get a chance to explain what causes inflation and how it can be kept at low levels, they really do not make much sense.
They could simply acknowledge the formidable role that monetary expansion plays in causing inflation, but they choose not to do so. Instead, they go on winding tirades in pursuit of other explanations.
As a case in point, consider the speech that ECB economist and Executive Board Member Philip Lane gave on April 15th. Lane spent a lot of time making the case for deflation, or disinflation as it is sometimes referred to; the trend Lane relies on is buried fairly deep in the data sets that economists use to analyze inflation.
Lane sees indications that there is indeed a persistent disinflation process underway in the euro zone. He also explained:
The role of monetary policy in the disinflation process has been to ensure that the large and persistent but temporary inflation shocks did not mutate into an increase in the medium-term inflation trend through the de-anchoring of inflation expectations.
Like most central bank economists, Lane refuses to admit that the inflation episode we are now on the tail end of, had its origin in excessively expansionary monetary policy. He repeats the official narrative that it was all a matter of supply-chain disruptions, which—as I explained almost two years ago—was not the case. There were disruptions, but they were not the cause of the inflation spike.
Right off the bat, Philip Lane’s argument loses its logic. If inflation is not a monetary phenomenon, as he claims it isn’t, then monetary policy cannot fix the problem of inflation either. If inflation had been caused by supply-chain disruptions, then raising or lowering the interest rate—and correspondingly reducing or increasing the supply of liquidity in the economy—will not do very much to mend broken supply chains.
There is another problem with the supply-chain explanation of inflation. It makes it impossible for economists in general, and those at central banks in particular, to rationalize why some countries continue to have high inflation even as supply chains are back to being fully operational again. To take just one example, the U.S. economy suffers no supply-chain disruptions, yet inflation remains in the vicinity of 3.5% per year. In 2017-2019, annual inflation was less than 2.2%.
The current American inflation problem has its separate explanation, one that I will return to in a later article. For now, let us get back to ECB economist Lane and his attempts to explain inflation as a non-monetary phenomenon. Once he has run out of supply-chain explanations of why prices still increase faster than 2% per year, he resorts to an analytical safe hatch that is very popular among economists.
That safe hatch is known as ‘expectations’ and can be used to explain anything that economists do not believe they have the analytical ability to explain in any other way. After having told us that the 2022-2023 inflationary peak was a supply-chain problem that could be fixed by monetary policy, Lane goes on to tell us that if inflation persists, i.e., if monetary policy cannot fix it after all, then the cause of inflation is a “de-anchoring of inflation expectations.”
This sounds very complicated, but all Lane is talking about here is that people’s expectations change. However, expectations are not proactive in determining economic activity—they are reactive, formed based on past experience. Economic decision-makers—in other words households and businesses—prefer stability and predictability in their outlook on the future. Therefore, their decisions on how much money to spend and what prices to set on goods and services are based on experience of the past more than expectations of the future.
Economists can do surveys of expectations all they want. Philip Lane reports the results of surveys of what inflation rate some economic analysts expect in the coming years. However, there is no evidence whatsoever that those expectations actually help the expected inflation rate come about. In fact, if expectations cause persistently high inflation, then businesses that continually raise prices (inflation) solely because they expect a certain inflation rate will sooner or later run into the realities of their economy. Since economists who believe in expectations downplay the influence of other variables, they do not run their expectations scenario through to the end. If a business keeps raising its prices for no other reason than its managers expecting a certain inflation rate, then a point will come when consumers stop buying the product. This leads to a price fall—deflation—and broken expectations.
Just like we cannot escape gravity, we should never disregard the good old economic laws of supply and demand.
This long analysis of how the ECB thinks about inflation leads to one firm conclusion: courtesy of its economist Philip Lane, the bank is trying too hard to avoid having to admit that inflation is a monetary phenomenon.
