Why has the ECB been so sluggish to respond? Looking backwards, not forward.

According to the European Commission's spring 2023 inflation estimates, which were released on May 15, this year's euro-area inflation will be 5.8%, somewhat higher than expected in the winter. The European Central Bank estimates that in comparison to April 2022, food prices in the eurozone were 15% higher in April. If inflation in the eurozone reaches 8.4% in 2022, then $100 in 2021 will only be worth €86 in 2023. Given the high prices the public must endure on a daily basis, it makes sense that they are impatient.

The ECB resisted taking action against inflation for the majority of 2022, claiming that since energy was a major contributor to the issue, its policies were ineffective. In the first quarter of 2022, the wager was that the conflict in Ukraine would be short-lived, energy prices would swiftly stabilize, and as a result, inflation would also quickly return to pre-conflict levels. The possibility of a protracted war and a global financial system that was becoming increasingly disjointed caught the ECB off guard.

Not that the ECB predicted the future incorrectly. Given the current level of uncertainty, it is improbable that anyone can predict the future with any degree of accuracy even one year in the future. To fully understand the future, the ECB has placed, and continues to place, too much stress on the past.

The ECB's focus on data reliance is indicative of this. For instance, ECB executive board member Isabel Schnabel stated on April 24 that the institution's actions will be "sstrictly data-dependent… it’s clear that further hikes are needed … but the size of the rate hikes is going to depend on the incoming data." Fair enough, the US Fed is likewise employing a similar strategy. On October 8, 2019, Chair Powell said, "At the Fed, we like to say that monetary policy is data dependent." But what new information that came in during October 2019 would have been helpful in getting ready for 2020, the year the epidemic struck?

There are significant delays in monetary policy operations of almost two years. The information that is being received today only illustrates how the economy has benefited from some of the initiatives that were implemented two years ago. Such information does not provide any insight into the future or current policy-making processes. And the less accurate the past and its data are at predicting the future, the greater the level of uncertainty.

In March 2022, immediately following Russia's invasion of Ukraine, inflation was running at 7.5% (although core inflation, which excludes volatile components like energy, was almost 3%). Instead of focusing on the past, policymakers ought to have tried to predict the future. What other sorts of evidence could have influenced policy in a different way? A few items that were on the radar would have provided a strong hint that inflation would not be temporary.

First, there was the anticipated fiscal stimulus. It turns out that starting September 2021, EU governments have granted funds to help businesses and households cope with rising energy costs. This assistance is comparable in amount to that allocated by the EU for economic recovery at the outset of the pandemic. Additionally, more money would have needed to be raised for the military and resources would have been needed to help Ukraine and all of the Ukrainians who were fleeing the war. All of this, amounts to a significant fiscal boost that has little effect on reducing inflationary pressures.

Second, by the end of May 2022, EU nations had made it plain that they would not halt (sanction) the imports of Russian energy in order to continue meeting their own energy needs. Energy costs would inevitably be under pressure as a result, staying high for longer.

Last but not least, even while salary increases as second-round impacts were not immediately apparent, the likelihood that they would occur increased daily.

When core inflation was close to 5% and euro-area inflation was close to 10% in September 2022, the ECB finally turned the policy rate positive.

This is however in the past. How about now?

The cost of energy has now dropped to pre-war levels. These days, wages and profits are the primary causes of inflation. The ECB won't likely cease raising interest rates until it observes decreases in inflation in the statistics because it was too late to begin doing so. In other words, it is about to commit the same error and leave the EU after its recovery has already been weakened.

A very terrible standard to subject oneself to is judging success by how well one prepared for the past. A policy that can withstand uncertainty avoids making future projections. Instead, it attempts to implement laws that will produce acceptable outcomes for the broadest range of scenarios.

By fLEXI tEAM