Time and again I look for it. And every time I do not find it. What is it about? I look for the word “money growth” in interviews and speeches by board members of the European Central Bank. That is strange and revealing at the same time.
Strange, because inflation in the long run is really related to how much additional money is added to an economy. The central bank has a big say here. If it is your job to manage inflation and you mention climate, wages, expectations, wars, weather and all sorts of things but not money growth, then I think you may question that.
It has not always been the case at the ECB, by the way. When the bank started, in 1999, money growth, also known as the monetary pillar, was one of the two pillars on which ECB policy was based. Later on, this pillar was lowered in the pecking order and eventually, without much fanfare, almost completely removed.
It is significant because, in my view, it clearly indicates that the ECB plays a subordinate role in the policy mix, that the bank complies with what the - larger - euro countries’ budgetary policy dictates. That is a worrying observation, I conclude after reading a recent paper by the BIS, the Bank for International Settlements.
Dominant policy regime determines impact
The bank argues that the effect on inflation in a country with a persistent budget deficit - there are quite a few of those in the eurozone! - depends on which policy regime is dominant, fiscal policy or monetary policy.
In fiscal dominance, a government does not adjust its primary fiscal balance to stabilise public debt and the central bank is either not independent of politics or places little emphasis on maintaining price stability.
In such a case, a 1 percentage point increase in the budget deficit leads to 0.5 percentage points higher inflation in the next two years. There is also a significantly higher probability of sustained excess inflation in the medium term, average inflation is higher and its volatility is higher, and so is uncertainty. By comparison, if monetary policy does not play a subordinate role, the inflation effect of a one percentage point increase in the budget deficit is only 0.1 percentage point. The BIS drew these conclusions after reviewing data spanning four decades in 21 developed economies.
Central banks play second fiddle
According to the BIS, the high inflation rate since the recovery from the corona pandemic can be reconciled with a regime in which fiscal policy is dominant and monetary policy is facilitative, say subordinate. According to the BIS, the fact that central banks play second fiddle is reflected in the fact that policy interest rates are generally below the levels prescribed by the Taylor rule. The Taylor rule is a policy rule that shows what official interest rate is needed to bring inflation to a desired level, currently 2 percent a year, for a long period of time and to keep it there. In the US, this is a Fed rate of between 4 and 7 percent, and in the eurozone it is between around 2.5 and 4 percent.
Recent revisions of monetary strategies by the ECB and the Fed may increase the inflationary impact of persistent budget deficits, according to the BIS. In other words, these revisions are a clear indication that central banks are accommodating to the policy needs of governments. Based on past experience, the shift to fiscal dominance will lead to structurally higher inflation than many are used to in the coming years, with greater volatility in it as well. Investors, take advantage of this legal inside information!
With regard to (monetary) policy, we are used to talking in terms of good or bad. I think we are now in a new dimension in the eurozone, where policy is not only bad but dangerous.
Edin Mujagić is chief economist of OHV Asset Management and author of the book ‘Keerpunt 1971’ (‘Turning point 1971’, in Dutch). Every last Friday of the month he writes for Investment Officer an ECB Watch on the monetary policy of the European Central Bank.
This column originally appeared in Dutch on InvestmentOfficer.nl.