On January 12th, Christine Lagarde, president of the European Central Bank, explained that interest rates in the euro zone have reached their peak:
“I think that we are at the highest point and barring additional shocks… rates are very probably not going to continue to rise,” Lagarde said in an interview on French broadcaster France 2. “I think they have reached their peak,” she said, but refused to be drawn on a possible cut to borrowing costs. “I cannot give you a date,” she told her interviewer.
This is a curious statement, given that market-based interest rates have been rising in the euro zone over the past month. The statement is also noteworthy because it puts a problematic limit on the ECB’s ability to conduct monetary policy: by ruling out increases in the ECB’s policy-setting interest rates, Lagarde prevents the ECB from tightening monetary policy any further than it already has. Its only policy options are to keep rates where they are, or to cut them.
Technically, the latter means printing more money.
But is it really such a bad idea to rule out higher interest rates? With the euro zone on its way into a recession, raising interest rates should be the last thing on the ECB’s mind, should it not?
As with so many other things, this one is not that simple. To begin with, the fight against inflation is not over: if the history of high inflation tells us anything, it is that once inflation is coming down again, the risk for rebounds is high. When those rebounds happen and inflation ticks up over a period of a few months, the central bank cannot be as stubborn as the ECB president is and simply rule out higher interest rates.
Furthermore, in addition to the fight against inflation, the ECB has another reason to not exclude higher interest rates. The governments in most euro zone countries are struggling with budget deficits, and the recession will only worsen their fiscal problems. The ECB has a history of accommodating budget deficits by printing money and then using it to buy government debt.
It is a given that euro zone governments will start borrowing money on a broad scale to plug the holes in their budgets. The problem is that, as they continue to sell more debt, the investors who buy it will eventually start demanding higher interest rates to keep on buying. The deficit-ridden governments in the euro zone know this, but it will not deter them: with the ECB’s history of coming to their rescue with freshly printed money, they can simply plan for the central bank playing the role of lender of last resort.
If the ECB wants to, it can promise all it wants that it will not play that role again. Christine Lagarde’s statement that the ECB is done raising interest rates effectively neutralizes any such promises. When an indebted government faces higher borrowing costs on the sovereign debt market than the policy rates set by the ECB, political pressure will mount on the ECB to intervene. This happened in the Great Recession in 2010 when the central bank summarily abandoned its constitutional duty not to buy sovereign debt.
Back then, as soon as fiscal imbalances erupted across the euro zone, the central bank put its money printers to work and went on a treasury security buying spree. It even issued a promise to buy any euro-denominated government debt, regardless of credit status, at a price that neutralized bad credit ratings.
Eventually, when the ECB had increased the euro zone money supply far enough, their monetary expansion caused inflation. It did so primarily through the program where the central bank purchased sovereign debt.
The link from money printing via budget deficits to inflation is well established, even by the ECB itself. On January 16th, the central bank published a compelling paper called “Monetary-fiscal policy interactions when price stability occasionally takes a back seat” (Working Paper 2889) by Sebastian Schmidt, principal economist of the ECB’s monetary policy research division. In this paper, Schmidt practically spells out that when the central bank is faced with widespread budget deficits in the euro zone, it will be forced into accommodating those deficits.
In short: return to buying unlimited amounts of government debt.
The default policy setting in Schmidt’s model is one where the ECB—simply referred to as “the central bank” in his paper—is concentrated on price stability by means of monetary conservatism. Then a scenario unfolds called “the fiscally-dominant regime,” where the central bank is concerned about the consequences of rising interest rates on sovereign debt. At that point, Schmidt explains, the bank would abandon its monetary conservatism and instead try to keep down borrowing costs for indebted governments.
So far, Schmidt’s paper follows well-known tracks in the economics literature. What sets his paper apart is that it establishes a clear link between the central bank caving to fiscal-policy demands, and the mechanisms that cause inflation. He finds that even “the occasional” outburst of monetary accommodation, i.e., money printing to help indebted governments, “results in a systematic failure to achieve the price stability goal.”
In plain English, Schmidt is spelling out that the ECB will not have to buy that much government debt with the help of newly printed money before it causes another outburst of high inflation.
There is one piece missing in Schmidt’s paper: an analysis of the causal link that transmits a monetary expansion to inflation. This is the so-called fiscal transmission mechanism: when a central bank pays for newly issued government debt with newly printed money, that money goes straight into the government budget. It is then used to finance government spending programs.
For reasons that my co-author and I elaborated on in detail in our paper “The Fiscal Transmission Mechanism of Inflation” (American Business Review, June 2023), this way of funding government programs is a rapid and dangerous way of causing inflation in an economy. We not only establish statistically that this transmission mechanism exists, but we also explain in detail how it works.
Together with Schmidt’s findings, our contribution makes a formidable case against any monetary accommodation of fiscal deficits. The ECB would be doing the euro zone member states a big service if it coupled a firm ‘no’ to printing money to buy government debt with an open door to higher interest rates.
This would force euro zone governments to manage their deficits on their own and therefore to make very tough fiscal choices. However, those choices are vastly preferable to the catastrophic consequences of reigniting monetary inflation in the euro zone.
If inflation returns in a recession, it will be in the form of stagflation, which could easily spin out of the ECB’s control.
