European Central Bank Should Tighten Monetary Policy Further

IMF Blog, July 21, 2023

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The European Central Bank could prevent inflation expectations from becoming unmoored and drifting upwards by continuing to raise its policy rate.
A further tightening of monetary policy in the near term would prevent much more costly measures later to bring inflation back to target.

The ECB Governing Council has raised its deposit-facility rate eight times, by a total of 400 basis points, since it started to tighten policy in mid-2022.
These decisive actions have helped keep longer-term expectations well anchored so far.

Prices in the euro area rose by 5.5 percent from a year earlier in June.
Core prices were up by 5.4 percent.
Core inflation in the three months to June was 4.6 percent on an annualized basis.
The original shocks to energy and food prices are dissipating, but inflationary pressures are likely to persist for some time.
The report does not see inflation coming back to target before mid-2025.
Inflation could prove more persistent if inflation expectations shift upwards or the share of wage contracts containing backward-indexation clauses increases.

The ECB should persevere in keeping monetary policy tight in the face of persistent inflation.
For a while, the ECB should react more strongly when inflation comes in above expectations than it does when inflation is below expectations—adopting a so-called tightening bias.
A tightening bias would help prevent high inflation from becoming entrenched—a bad outcome that would ultimately force the ECB to tighten more and for longer to return inflation to target, causing a sharper economic downturn later.
If the ECB were to raise its policy rate further and possibly above the 3.75 percent peak that markets expect now, depending on incoming data, this would help significantly to prevent high inflation from becoming entrenched.
Faster convergence of inflation towards the 2 percent target would allow interest rates to fall at a faster pace thereafter.

The ECB’s meeting-by-meeting approach to making policy decisions rightly allows it to set rates based on the evolving inflation outlook, and incoming information on the drivers of underlying inflation and the strength of monetary policy transmission.
The ECB should remain flexible given the economic uncertainties ahead and be ready to adjust course depending on the flow of data.

Alfred Kammer, Luis Brandão-Marques — July 21, 2023