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‘Living in a fantasy’: euro’s founding father rebukes ECB over inflation response

Like many Germans, Otmar Issing is alarmed by the rise in inflation to its 40-year high in his country and concerned about the European Central Bank’s “misguided” response. But as one of the founders of the euro, Issing’s complaints outweigh most of his compatriots.

The ECB’s first chief economist, when the ECB was founded in 1998, said the central bank had been “misdiagnosed” as to the factors behind the price hikes, because it “lived in a fantasy” that threatened an out-of-control downplayed inflation.

“The ECB has contributed immensely to this trap it is now trapped in as we head for the risk of a stagflationary environment,” said the 86-year-old, who is credited with shaping the central bank’s use of money supply measures to set interest rate policy. .

His criticism that the ECB is too slow to raise interest rates underscores the heated debate in Germany and much of the eurozone’s 19 countries about how quickly to roll back eight years of ultra-easy monetary policy – ​​including negative interest rates and € 4.9 trillion from bond purchases.

After struggling to get inflation up to the 2 percent target for the past decade, the ECB is now facing the opposite problem. Consumer prices are skyrocketing as the European economy recovers from the deep recession caused by the pandemic. In March, inflation in the eurozone reached a new all-time high of 7.5 percent.

“Inflation was a sleeping dragon; this dragon has now awakened,” Issing told the Financial Times at his home in Würzburg.

The ECB’s Governing Council is meeting in Frankfurt this week to discuss whether a plan to phase out stimulus should be accelerated by ending net bond purchases in the third quarter. At their meeting last month, some of its policymakers called for an earlier halt to bond purchases to pave the way for interest rate hikes this summer.

Line chart of the harmonized index of consumer prices (annual change in %) showing that eurozone inflation reached a record high in March

Many central banks, including the US Federal Reserve and the Bank of England, have already stopped buying bonds and have started raising interest rates.

“It is clear that the ECB is late to respond, while the Fed may be even more behind the times,” said Issing, who has chaired the Center for Financial Studies at Goethe since he left the ECB in 2006. university in Frankfurt.

His former colleagues at the ECB predict that many of the factors driving the price of energy, food and other commodities will quickly disappear from the end of this year, pushing inflation back below 2 percent by 2024.

But Issing said this ignored the risk that the pandemic and Russia’s invasion of Ukraine will keep inflation higher by reversing 30 years of globalization as trade tensions mount, companies make supply chains more resilient and Europe accelerates the transition from fossil fuels.

“The ECB relied on its forecasting model and this model cannot give the right signals because it is based on the past and cyclical experience – and the pandemic did not trigger a cyclical downturn,” said Issing.

“You need a much broader approach to explain inflation at a time of structural change. If you are misdiagnosed, of course you have a misguided policy.”

Other German financial figures have stepped up their criticism of the ECB. Christian Sewing, chief executive of Deutsche Bank, Germany’s largest lender, said last week that rising inflation was “poisoning to the stability of our economy and society” and that it was “urgent” for the ECB to intervene.

Axel Weber, the outgoing chairman of UBS and former head of the German central bank, told the financial newspaper Handelsblatt that it was “incomprehensible” that the ECB took so long to change its policy. Bild Zeitung, the country’s best-selling tabloid newspaper, has begun referring to ECB President Christine Lagarde as “Madame Inflation”.

Germans have a deep-rooted fear of inflation, which Issing says “goes back to hyperinflation in the 1920s and currency reform in the 1940s.” † † It’s almost in the public’s genes.” But he said the concerns were “not just that the Germans are pathological about inflation – you can see this in all countries”.

Line chart of the ECB deposit facility rate showing Sub-zero: how the ECB cut rates into negative territory

Several ECB policymakers, including chief economist Philip Lane, have said there is little they can do to address external factors driving energy prices up, while fearing that a rate hike too fast could trigger a serious downturn, especially if the war in Ukraine continues. the flow of oil and gas from Russia to Europe.

Both Lagarde and Lane have said the ECB could even introduce a “new instrument” to support countries facing sharp rises in borrowing costs as interest rates rise. Their staff is already working on such a “crisis tool” to make targeted purchases of government or corporate bonds if necessary.

Issing now agreed that it was “not the time to raise interest rates to high levels”. But he said the ECB had maintained its stimulus measures for too long, which was “very hard to defend” given the recovery in growth and inflation, while unemployment has fallen to historic lows.

“The ECB lived in the fantasy of continuing this policy without any negative consequences,” he said. “They would be in a better, or at least less bad, situation if they had started normalizing policies sooner – the war shouldn’t be allowed to distract from this fact.”

The prospect of a “stagflationary” situation of rising inflation and slowing growth is “the worst combination” for a central bank, said Issing, who contrasted monetary policymakers’ reactions to the two oil shocks of the 1970s.

“The Bundesbank tried to control inflation and the result was moderate inflation and a mild recession,” said Issing, who joined the Federal Reserve in 1990. But “the Fed waited too long” and the US had “double digit inflation and a deep, deep recession”.

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