European dependence on fossil fuels poses a risk to price stability. That is according to Frank Elderson, the Dutch member of the Executive Board of the European Central Bank (ECB). Energy shocks, which seem to occur with increasing frequency, are making it ever more difficult for the ECB to keep inflation at 2 percent per year.
This seems to imply that the ECB always has inflation neatly under control, if it were not for energy shocks. That interpretation would be incorrect. The bank cannot exactly boast a strong track record when it comes to achieving price stability.
Elderson does have a point when he argues that central banks can normally look through rising oil prices, but that doing so is currently quite difficult.
Looking through an increase in oil prices is advisable because the central bank can only respond with an interest rate hike. However, if oil prices rise due to a war, there is a very high likelihood that by the time a rate hike takes effect, the oil price increase will already be long over and far enough in the past that the shock is almost forgotten.
The problem now is that when oil shocks occur relatively close together, as they do at the moment and as they did in 2022 due to the war in Ukraine, looking through them—in other words ignoring them—carries the risk that inflation remains too high for too long. That, in turn, is damaging to the reputation and credibility of the central bank.
There is, however, one important caveat regarding the above and the ECB’s role since 2011, and that is that the bank spent far too long looking through inflation back then (in 2021 and 2022). Inflation in the eurozone was already quite elevated before the war in Ukraine broke out, and the ECB did nothing. When many other central banks subsequently raised interest rates to combat inflation, the ECB again remained on the sidelines.
Residents of the eurozone have not forgotten that episode; it is still too fresh in their memory. That is one reason why the ECB cannot afford to look through inflation now.
The ECB policymaker’s solution is to accelerate the energy transition. The reality, however, is that the energy transition will still take years, even if accelerated, so it does not solve today’s problem. The reality is also that high energy prices and inflation are affecting many people right now.
Instead of focusing blindly on ideology and the ambition to achieve the energy transition, the ECB should take reality into account. Many people do not have the luxury of waiting for a long energy transition; they are already feeling the pain. That means some sacred cows may need to be challenged, such as restarting German nuclear power plants, reintegrating nuclear energy into the energy mix, better connecting electricity grids to increase competition within the EU, and postponing the planned closure of coal-fired power plants.
Yes, that would mean reaching self-imposed climate targets later. But the reality is that those agreements were made in a world that looked very different from today. It is therefore reasonable to question whether those targets should be adjusted, for example by slowing the pace of reducing CO2 emissions by half and achieving climate neutrality.
Finally, what should also stop is the ECB involving itself in matters that are fundamentally political, such as the energy transition and the structure of the EU. In that respect, I am looking forward to the arrival of Kevin Warsh later this year as chair of the Fed. One of the things he wants to achieve is for central bank policymakers there to speak less often.
So fewer interviews, fewer speeches, and fewer hints about what the bank may or may not do in the future. The future path of interest rates depends on what the future brings, and that cannot be predicted. This forward guidance—the policy of conditioning markets on what the bank will do in the future—only creates more uncertainty and volatility.
Speaking less often would not be a bad idea for the ECB either.
Edin Mujagić is an economist, manager of the Hoofbosch Investment Fund, and author of the book Turning Point 1971. He writes a monthly ECB Watch for Investment Officer on the monetary policy of the European Central Bank.