MNI INTERVIEW: Loose Fiscal Policy Could Push ECB Rates Higher

A commitment to improve the eurozone’s fiscal balance by around 0.5% of gross domestic product next year is insufficient and could force the European Central Bank to raise rates higher than otherwise as well as push up government financing costs, European Fiscal Board Chairman Niels Thygesen told MNI.

Given the planned withdrawal of measures put in place to assist economies through the 2022 energy price surge, and with economic activity forecast to be back to normal by 2024, support by eurozone finance ministers for a 0.5% fiscal tightening is “not enough”, Thygesen said in an interview. (See MNI SOURCES: Data Deluge Clouds Early ECB September Rate Call)

“Fiscal policymakers should not ignore inflation risks. To do so could pressure the ECB to raise rates further,” he said, “potentially increasing the pressure on government bond spreads and so increasing the costs of bringing down inflation.”

The failure of fiscal policy to keep pace with rate rises by the ECB, which in its June projections assumed a 0.8% GDP tightening of the eurozone fiscal stance next year, could mark a return to the pre-pandemic norm of less coordination between the two policy domains, according to Thygesen.

MONETARY POLICY LAG

“The ECB is capable of changing direction and modifying its stance quite quickly – it took too long in 2021 and 2022 - but it did so and it’s looking for a little help in stopping it going too far in the other direction now,” he said, though he admitted that the debate over how to coordinate fiscal and monetary policy is complicated by uncertainties over how quickly interest rate rises affect demand. (See MNI INTERVIEW:Inflation Should Slow In Time For Sept ECB Pause)

“That is where some of the debate is now because the ECB doesn’t itself know how strong exactly the impact of the policies they have already implemented will be in 2024. If you look at their own work, there are some divergences there. So, they are not in a position to give very clear quantitative advice,” he said.

His comments followed the statement by the Eurogroup of eurozone finance ministers on July 13 backing a European Commission recommendation for an average improvement in governments’ structural balance next year of around 0.5% of GDP and for the winding down of measures implemented in the wake of Russia’s invasion of Ukraine.

Thygesen welcomed the stress by Eurogroup chief Paschal Donohoe on the need for “complementarity” between fiscal and monetary policy.

“That’s useful terminology in sense that monetary and fiscal policy should not be substituting for each other,” he said.

“Traditionally in very normal times the division of labour was that fiscal policy was conducted on the basis of political preferences and then if the central bank thought it was too risky, particularly on the inflation side, they would step in and tighten,” he said.

“But then we got into such a deep trouble with the pandemic and energy crisis that the emphasis shifted to doing things jointly in an expansionary direction and once you’ve shifted it’s difficult to shift back. There isn’t this flexibility in the political attitude.”