MNI INTERVIEW:ECB Dilemma As German Inflation Outruns Eurozone

Inflation in Germany is set to remain higher than in other core eurozone countries for some time, raising the risk that the European Central Bank could push rates to levels which are too tight for other parts of the bloc, Markus Demary, senior monetary policy and financial markets economist at the German Economic Institute (IW), told MNI.

The ECB could continue hiking into 2024, possibly increasing rates once or twice more in the first half of next year, Demary said. Market pricing currently implies the ECB will hike by another 50 basis points to a peak of 3.75% around October, before cuts become more likely next year. (See MNI SOURCES: Most At ECB See 4% Rate As Only Outside Chance)

“We are not going back to a low inflation environment,” Demary said. “We are back in the old world with inflation slightly above the ECB’s inflation target, with monetary policy leaning against upwards price pressures with further increases in interest rates.”

TOO RESTRICTIVE

With German inflation likely to average around 6% this year and 3-5% next year, compared with the ECB’s March euro area average projections of 5.3% and 2.9%, policymakers may be tempted to skew policy towards Europe’s largest economy, he warned.

“If monetary policy does focus on Germany it may be too restrictive for other countries. We had that discussion in the ‘80s and ‘90s, where monetary policy was too restrictive for France and Italy,” he said. “Yes, we have a monetary union now. But we could go back to this kind of controversy of the past if the inflation rate in Germany proves to be problematic for other Eurozone member countries.”

High levels of pandemic-related household savings have so far translated into relatively stable consumer spending, in turn allowing companies - some of which have seen wage costs increase significantly amid tight labour market conditions - to put up prices.

“If you have stable consumption there is room for companies to increase their prices,” Demary said. “Probably there is still room for higher wages, but if laying off workers is not an option then the only alternative is to pass these additional costs on to consumers. And that could again result in mildly higher inflation - 3-5% - which is sticky.”

Overall, Germany’s economy faces “very serious” downside risks to growth stemming principally from the restructuring of energy markets following Russia’s invasion of Ukraine, Demary said, citing the current inadequacy of renewable energy sources and the slow pace of transition as key concerns. (See MNI INTERVIEW: Europe Faces Slow Growth- German Gov't Advisor)

“The question is how fast we are going to transform our economy towards, on the one hand, carbon neutrality, and on the other hand, cheap energy,” he said. “In the next years we cannot do both at the same time.”

Some dampening effect on inflation is likely as rents for housing stagnate or fall, Demary said. But the disinflationary effect of the introduction from May of a EUR49 per month flat-rate ticket for all rail travel within Germany may be limited, with much of the resultant savings spent on food, which is increasingly expensive.

FISCAL POLICY

Thanks in part to such measures - and proposed energy subsidies for businesses - fiscal policy is likely to remain mildly expansionary, adding to inflation. At the same time, rising interest costs will force to the government to trim investment, with potentially damaging consequences for longer-term growth.

“Net interest payments have increased, and it will limit fiscal space for the German government a little bit - although it's not severe - especially for infrastructure spending. Germany is trying to transform its economy to become more digital and more carbon neutral, but if conditions are better for companies to invest in other regions then they may start moving,” Demary said.

Net interest payments will total around EUR39bn or 8.2% of total expenditure in 2023, according to ratings agency Scope.