A Sword of Damocles Hangs Over Monetary Union: Models aren't working.

• Author: Issing, Otmar

During the Great Moderation, a long period of low and stable inflation, continuous growth, and moderate unemployment, the risk of higher inflation was off the radar, even in central bank circles. And since inflation started to rise well above the 2 percent target in 2021, quite a number of central banks have been in the "transitory" camp, expecting inflation to return to prior low levels via self-correction, so to speak, mainly due to energy prices ceasing to rise any further, then falling again and global potential output significantly improving.

As recently as February of this year, the European Central Bank's Philip Lane argued that "since bottlenecks will eventually be resolved, price pressures should abate and inflation return to its trend without a need for a significant adjustment in monetary policy." As a consequence, central banks saw no need for action to counter the risk of higher inflation. Until the end of last year, the ECB even went so far as to communicate that sooner rather than later it would once again face a situation of too-low inflation by projecting inflation rates to fall below its target of 2 percent.

This was probably one of the biggest inflation forecast errors since the 1970s. Even before the Russian attack on Ukraine, the ECB had to continuously revise its inflation assessment upwards. Any forecast of inflation is based on assumptions about various exogenous variables, with oil and other energy prices playing an important role. This is the reason why the ECB uses the term projections--signalling that the staff bases its work on assumptions.

The problem of the ECB's severe underestimation of inflation since mid-2021 has a deeper source. It has largely ignored how the traditional models, including those to estimate potential output, were unable to take the substantial structural changes into account. The pandemic, as a combination of supply and demand shocks, entails a persistent negative shock on the output potential and is a major source of structural problems which had to be addressed by targeted and temporary measures of fiscal policy. Especially the U.S. Federal Reserve, but to some extent also the ECB, have underestimated the inflationary impact of expansionary fiscal policies via boosting domestic and global demand for goods and energy.

A major, deep structural change is taking place on the global level. In an important 2020 book, Charles Goodhart and Manoj Pradhan analyzed the main factors which will bring a change in the international environment from a disinflationary impact to a world where inflationary influences will dominate. Demographics is a major factor, but also the rise of protectionism. The Russian war and concerns about future tensions with China will strengthen the intention in all countries to reduce dependency on foreign sources of energy as well as other essential products.

What are the consequences of these and other developments for the monetary policy of the ECB? It is hard to understand why the ECB has been remaining in the crisis mode it adopted after the financial crisis in 2007-2008 and the sovereign debt crisis in 2010-2012. Zero or even negative interest rates and still net purchases of bonds-quantitative easing--were no longer appropriate in a period when the economy was improving and unemployment was at its lowest level since the start of the euro.

Now, with inflation rates not seen during the existence of the euro, the ECB has just started a very late exit from the monetary policy crisis mode. It is true that monetary policy cannot control energy prices and should look beyond temporary price shocks. Its role is to prevent inflation expectations from losing their anchor and wages and profits starting an upward trend. The pandemic, war-induced military spending and other geopolitical crises, aging populations, and not least climate policy will contribute to higher public spending. This implies a strong risk that public debts, having already reached historically high levels, will increase further, with consequences for the sustainability and credibility of public finances in a number of countries. Efforts to weaken...