MNI INTERVIEW:Inflation Should Slow In Time For Sept ECB Pause

Proof that euro area average core inflation is heading downwards could arrive in September, supporting a pause in the hiking cycle, a senior German economist and government adviser told MNI in an interview.

European member states’ annual inflation rates will also be within pre-crisis ranges by 2025, even as reinvestments from the European Central bank’s pandemic bond buying programme continue until the end of next year, said Klaus Adam, University of Mannheim economics professor, Bundesbank research professor and advisor to the Germany finance ministry.

Average annual euro inflation stood at 5.5% in June 2023, but there was considerable heterogeneity between countries, as harmonised measures in Belgium and Spain dipped to 1.6%, compared with 5.3% in France, 6.7% in Italy, 6.8% in Germany, and 11.3% in Slovakia.

“If headline is your target there is going to be some heterogeneity, at least temporarily, partly because of fiscal policy measures. So I wouldn’t read too much into it. Two years down the road it’s all going to have normalised,” Adam said.

The ECB is expected to raise the deposit rate by 25bp to 3.75% this month, but September may see a pause, with Dutch central bank governor Klaas Knot - regarded as a monetary policy hawk - recently describing a hike that month as a “possibility, but by no means a certainty.” (See MNI INTERVIEW: ECB Pause Likely In Sept-ExBank Of Cyprus Chief)

CORE INFLATION PLATEAU

Core inflation has essentially plateaued, Adam said, although “we cannot be really on the safe side until we see that going down. Will we have further indications by September that that's going to happen? I think there are some reasons why we might - and that has to do with the PPI going negative, which is going to put downward pressure on goods prices, while in the service sector we won’t see big wage increases.” (See MNI SOURCES: Data Deluge Clouds Early ECB September Rate Call)

But upside inflation shocks cannot be ruled out, and rates may still have to go higher.

“That would be particularly harmful, because everyone's now set on everything resolving in a benign way,” Adam said. “Certainly past rules that describe past reactions to high inflation would prescribe higher rates - all the way up to 5%, not stopping at four. That is a risk.”

Having raised rates by 400bp since last summer, and amid debate over how much tightening effect may be in the pipeline, it would be a mistake to assume that monetary policy lags “were ever very long,” Adam said. Instead, high frequency data suggests Europe’s long-anticipated economic downturn may be close.

“We were expecting a recession last fall, but because of all the accumulated household savings that just wouldn't come. Now these things are showing up: we see it in consumer spending; we see it in the construction sector; business investment is not too strong either. So I think it's going to come.”

With attention shifting to the central bank’s balance sheet as rate rises plateau, Adam thought it unlikely that policymakers will vote for active quantitative tightening - selling bonds bought under the Asset Purchase Programme, even though markets would be able to absorb such a move.

“The risk is always that it’s feasible until it isn't. Then the ECB could be forced to activate the Transmission Protection Instrument which they would very much prefer not to. It’s not clear to me what policy objective moving at a faster pace would achieve.”

PEPP REINVESTMENTS

Rate-setters are also unlikely to renege on their oft-repeated commitment to continuing reinvestments from the Pandemic Emergency Purchase Programme until at least the end of the 2024, he said, due to credibility concerns.

How large the ECB’s balance sheet should ultimately be “nobody knows,” Adam said. While excess liquidity parked at the central bank has to be remunerated, leading to losses for the Bundesbank among others, “the losses argument is really not an argument for reducing the balance sheet.”

Nor would the ECB be advised to adopt a corridor rather than a floor system for rates following the conclusion of a review into its operational strategy, he said.

“I don't think it's a great idea to try to pinpoint the intersection of supply and demand, the quantity and the price - you could just fix the price and get where you want to be.”