Europe’s Knife-Edge Path Toward Beating Inflation Without a Recession

Tight monetary policy for longer

Faced with such uncertainty, central banks should maintain tight monetary policy until core inflation is unambiguously on a downward path back to central bank inflation targets. Further increases in policy rates are required in the euro area, while central banks in emerging European economies should stand ready to tighten further where real interest rates are low, labor markets are tight, and underlying inflation is sticky.

In fact, high uncertainty strengthens the case for tight monetary policy. If the inflation outlook is uncertain, there is more to lose from reacting too late rather than too early, because underestimating persistence would entrench high inflation and force central banks to tighten later for longer. This would likely require a sharp recession to bring inflation back to target.

Similarly, when the extent of economic slack is uncertain, monetary policymakers should place more weight on inflation and labor market dynamics, both of which now favor higher interest rates. Furthermore, even accounting for elevated uncertainty, policy rates in a number of countries are at the lower end of commonly used benchmarks suggesting that higher rates may be needed to rein in inflation.

Alfred Kammer on the Regional Economic Outlook: Europe