Previously published on May 11, 2022 in
By Milton Ezrati, Chief Economist at Vested
The European Central Bank (ECB) has made the Federal Reserve’s (Fed) job harder. After dangerously ignoring inﬂation for months, Fed Chairman Jerome Powell has at last adopted an anti-inﬂationary policy stance.
The Fed will gradually unwind its former practice of directly buying securities on ﬁnancial markets—what central bankers refer to as “quantitative easing.” Sales from the hoard of securities built up in past buying will siphon inﬂationary liquidity from ﬁnancial markets and the economy. Policymakers have also begun what looks like a long string of interest rate hikes.
Many see these steps as too little, too late. Still, the ECB’s decision to take no anti- inﬂationary action will make the Fed’s ﬁght that much harder and promises to inﬂict price pressures in both Europe and the United States for longer than otherwise.
In the face of European inﬂation reports almost as severe as in the United States, ECB President Christine Lagarde has all but refused to take action. She has talked about ending the bank’s quantitative easing program, perhaps not until September. Interest rate increases, she has stated, will wait until late this year, if then.
Lagarde explains her lack of action by drawing two distinctions to the American situation. Europe, she asserts, is less far along in its post-pandemic recovery than America, and its economy is much more vulnerable to the sanctions imposed on Russia. These are indisputable facts but still are no reason to ignore inﬂationary pressures.
The Fed’s lack of aggressiveness and the ECB’s outright passivity are especially distressing because today’s inﬂation—on both sides of the Atlantic—stems from more fundamental and stubborn sources than policymakers want to admit. The official line in both Washington and Brussels is that the inﬂation is the result of post-pandemic supply chain problems and the fallout from the war in Ukraine, especially the sanctions placed on Russia.
Undoubtedly, the supply chain difficulties and the sanctions have contributed to inﬂationary pressures. Still, an exclusive focus on them ignores the deeper, more fundamental roots stemming from years of misguided ﬁscal and monetary policies that neither central bank can rectify easily or quickly.
For over a decade now, Washington and governments throughout the European Union (EU) have pursued extremely stimulative ﬁscal postures that have created extremely wide budget deﬁcits. Each continent has faced a succession of crises that seemed at each stage to require such policies, but the pattern over this long time has nonetheless created economic imbalances.
Worse, from an inﬂation standpoint, the authorities on both continents have used extremely expansive monetary policies to ﬁnance these ﬁscal policies. The Fed in the United States, for example, has used new money creation to purchase some $5 trillion in government debt over the past decade, $3 trillion in just the last couple of years.
This is the modern equivalent of ﬁnancing government by running the printing press— a classic prescription for inﬂation.
This kind of underlying inﬂation problem would impose a tough ﬁght on the combined efforts of both central banks, but the ECB’s inaction will burden the Fed tremendously. Rising interest rates only in the United States and direct withdrawals of liquidity from ﬁnancial markets will tend to lure funds from Europe. Such movements are already evident in the dollar’s rise in foreign exchange markets. It has risen some 12 percent against the euro in just the last four months and is now higher than in the last six years.
This drawing off some of the inﬂationary fuel in Europe will do some of Lagarde’s work for her. At the same time, it will make the Fed’s efforts to draw down the inﬂationary liquidity in American markets that much more challenging. Effectively, the Fed will be conducting the anti-inﬂation ﬁght for both central banks. That burden will call for bolder action from Powell and his colleagues than if the ECB were cooperating. It will also prolong the inﬂation ﬁght for longer than would otherwise be necessary.
The Fed has already made its job more difficult by wasting a year denying inﬂation when it could and should have been pursuing policies to stem price pressures. That has allowed an inﬂationary psychology to embed itself into the situation, which, the experience of the last great inﬂation in the 1970s and 1980s shows, can make the anti- inﬂation ﬁght that much more difficult. Now Lagarde and the ECB have added to the difficulties. The only thing to conclude is that inﬂationary pressures will trouble both Americans and Europeans for some time to come.