Tue. Jan 18th, 2022

The last time German inflation was as high as it is now, in June 1992, was the Bundesbank’s benchmark lending rate, the Lombard rate, 9.75 percent. Today, the European Central Bank, the Bundesbank’s successor, charges banks in Germany, as well as the broader euro system, zero.

Much has changed since the summer of 1992. Twenty-nine years ago, the united German state was in its infancy and monetary union had yet to be born. This is, according to a note issued Tuesday by research group Laburnum Consulting, the last of these two changes that do more to explain why the gap between rates then and now is so large.

As we enter 2022, the ECB is breaking with a different tradition. For the first time in more than a decade, policy makers in Frankfurt are charting a different rate than that taken by the Federal Reserve and the Bank of England, each raising interest rates or considering it in the next few months in response to the rise in inflation seen over the past year. The ECB has meanwhile set to stop rates late for the duration of this year. The Laburnum note – written by Laburnum founder and former Bank of England official John Nugée and economist Gabriel Stein – thinks it’s partly because the eurozone’s monetary guardian sets policies with the region’s heavier sovereign debt in mind:

Why is the ECB so reluctant to act? We think the answer may be a fear that the political consequences of an attempt to aggressively bring down inflation may outweigh the economic consequences of continued lack of action. And behind this we feel a fundamental change in the ECB itself …

One of the key features of the pandemic was a surge in EA government debt, especially (though not exclusively) in Southern Europe. According to The Telegraph, France’s debt / GDP ratio is currently 118%; Spain’s is 120%; and Portugal’s is 135%. Much more worrying, Italy’s is 155% and Greece’s debt / GDP ratio, after repeated restructurings and write-offs, is 206%!

These are worrying figures, and even more worrying for the ECB will be the contrast with Northern Europe, where Germany’s debt to GDP in particular rose by only 4 percentage points in the same period, from 65% to 69%.

Consequently, the ECB is basically trying to provide one monetary policy for two very different economies, one with very heavy debt and one that is less so.

This, Nugée and Stein argue, will lead to the ECB once again coming under fire in the German popular press because it favors the money zone’s more loose members, at the expense of the more frugal.

We agree that this narrative is likely to play out. And as the months go by, the ECB may seem reluctant to remove support for reasons that economic factors alone do not explain.

While workers here are not yet experiencing the kind of wage growth that their American counterparts have, there are increasing signs of oppression in the labor market. Here is a chart from an email from Nomura’s economists, which piqued our interest when it landed in our inbox in mid-December:

Although the ECB is an outlier in terms of its plans for the coming year, central banks may still have much more in common with each other than their previous generations of policymakers.

Despite the shift in rhetoric from the Fed, the gaping gap between rates now and rates then is a similar extent in the US and Germany. The last time U.S. inflation was above 6 percent, in the fall of 1990, the effective federal fund rate was about 8 percent. Today it floats above zero.

There is a gap between where rates are currently and where they were the last time we saw inflation as high as it is at present.

There are good reasons why they do not have to be as high today as they were in the early 1990’s. For example, governments, firms, and households are now more indebted – relatively small increases in rates will have a greater impact on behavior than in the past. Price pressure can be a different animal this time as well. Some of the inflation we have seen lately is in markets for goods such as used cars. Such inflation has been linked to pandemic-related supply shortages and could very well disappear as businesses adapt to a world with Covid-19.

Yet a question hovers over the extent to which aggressive fiscal spending and monetary easing have led to something more lasting happening with inflation than rifts in global supply chains alone can justify. Rates do not have to rise as high as 10 percent. But if (and – in our opinion – it remains a big as), higher inflation becomes endemic, then they will have to rise terribly much higher than any monetary policymaker takes possession of.

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