Wide Angle Shot: Central banks & inflation 1970s back? No, for real rates yes!

After the surprisingly strong — albeit turbulent — economic recovery from the pandemic, the next phase of weakness (even without a comprehensive gas embargo) beckons with the escalation of geopolitical tensions due to the Ukraine war. This is especially true for Western Europe. Here economic growth could be closer to one per cent in 2023. A noticeable growth slowdown coupled with high inflation (at least above the 6% mark inside the euro area this year) represents a delicate environment for ECB. Under normal circumstances, concerns about the economy are accompanied by inflation-dampening effects, so central banks ease monetary policy to support the business cycle. In the current environment of pronounced inflation risks ECB considers a certain normalisation of monetary policy or a less expansionary monetary policy to be appropriate despite downside risks to the economy. This is true even if many inflation drivers in Western Europe are clearly supply-side driven. Inflation is made in Beijing, Moscow or Brussels here, less so in Frankfurt. Nevertheless, vigilance is needed as already in the course of the economic recovery in the aftermath of the Corona crisis inflation has proved more persistent than previously assumed. Inflationary pressures in Europe are also increasingly broad-based and entrenched. Core inflation inside the euro area is running at 3%+ currently, the highest level for years. Overall inflation has already reached historic heights not seen for decades in Western Europe. Now the Ukraine war is threatening new trouble on the inflation front, a broad-based global price shock beyond the energy sector is looming. And on the other side of the Atlantic, there is already increasing discussion about whether the US Fed has been too hesitant for too long. Or in other words: Now Fed must aggressively tighten monetary policy. The idea of "letting the economy running hot" with inflation being elevated "only temporary" has failed miserably. For the US Fed, the market is currently pricing in a discernibly restrictive key interest rate path with the risk that Fed will first have to push up the key interest rate very high before easing it again somewhat.

In light of the developments on the USD money and bond markets in recent weeks, it should come as no surprise that the interest rate landscape in Europe by no means declined in recent days and weeks as is usual in times of (geopolitical) crisis. This was only the case in an initial reaction to Russia's invasion of Ukraine. Back then the 10-year German government bond yield briefly fell back below the zero per cent mark. However, it was not long before the pre-war level was reached again, which was then even clearly exceeded. For the first time since 2014, the 10-year German government bond yield is now once again recognizably trading above one per cent.

It is short- to long-term inflation expectations that have once again increased significantly on financial markets since the beginning of the war and thus boosted the euro area yield level into a new territory. Inflation expectations for the euro area priced on the financial market have clearly exceeded the 2 percent mark and are thus at the upper edge of the ECB's tolerance range (and this also taking into account possible risk and/or liquidity premiums in this market segment). Currently, longer-term inflation expectations on capital markets are even noticeably above medium-term inflation estimates of the economists surveyed by the ECB (even though these have recently increased significantly and are also close to 2 %). In this respect, for the first time in years, there is a positive so-called "inflation premium" on European fixed income markets. In other words, the financial market expects significantly more inflation in the medium term than economists. Here inflation is expected to consolidate above ECB's target value. Not to forget that ECB has prominently discussed the importance of inflation expectations in its strategy adjustment process (see here). And the medium and longer-term inflation outlook should not be weighed down in the coming years by special factors that were formative in the 2010s inside the euro area (e.g. deleveraging in the private sector in some euro countries, very low inflation in Germany and internal devaluation in relation to this in some euro countries). Sustained positive (nominal) yield levels for benchmark interest rates in the euro area also show that financial markets are now clearly expecting a monetary policy turnaround by the ECB despite a muted outlook for economic growth.

The first step will be a clearly communicated phasing out of substantive net bond purchases and the second step will be key interest rate hikes. A hectic departure from this long-communicated guidance does not seem advisable; interest rate hikes are possible in July even with this guidance. A reduction of the accumulated bond holdings, as the US Federal Reserve intends, or even an outright end to the regime of generous central bank liquidity, on the other hand, are not (yet) an immediate topic at the ECB (especially since even the Fed will maintain a larger balance sheet in the future). We currently consider a first ECB rate hike in Q3 likely, by the end of the year the policy of negative ECB key rates could be more or less clearly ended with two or three rate hikes. However, ECB will from our understanding subsequently retain the necessary flexibility to react to changes in the inflation outlook and to accelerate or decelerate monetary policy normalisation. It cannot be completely ruled out that ECB will at some point have to act as pragmatically as the US Fed did with regard to key interest rates. At the same time, the exit from the ultra-expansive monetary policy is much more complicated at the ECB than at the Fed. The ECB has used many more unconventional monetary policy instruments and expanded its central bank balance sheet (in relation to GDP in the euro area) much more. The latter, in combination with the (unresolved) sovereign bond market fragmentation inside the euro area, suggests a balanced approach to exiting the regime of ultra-expansionary monetary policy in Europe. We believe that ECB will allow itself some leeway to raise key interest rates, but at the same time will keep a careful eye on liquidity and financing conditions in terms of bank lending and on credit and sovereign bond markets. In this respect, a renewal of long-term refinancing operations can be expected in the coming years. Even a more selective market-stabilising bond-buying programme cannot be ruled out either (see a noteworthy speech by French central bank governor).

In light of stagflation risks outlined above, parallels are being made — some of them prematurely — to the 1970s. Especially since inflation rates in the USA and Europe are currently at their highest level since the end of the 1970s and the beginning of the 1980s. And back then, too, war-related energy price shocks stifled economic development and fueled inflation. At that time, some central banks underestimated the inflationary shock — something ECB is currently being accused of — or had less clear inflation fighting mandates than today. However, as a reminder, in the USA and even in Germany the inflation rate was already above the average of 2% in the 1960s. While this mark was exceeded in Germany from early 1970 to 1984, the phase of elevated inflation in the US lasted as long as 20 years (from 1966 to 1986). Therefore, the starting position is somewhat different today coming from a low-flation regime. More importantly, we do not think that leading central banks like the Fed and the ECB will simply repeat the mistakes of the 1970s and allow the current price shock to become permanently embedded in people's and investor's minds in the form of higher inflation expectations. Moreover, at present monetary policy reaction functions of major leading central banks should not be reduced to the key interest rate policy only. And with regard to the scaling back of unconventional monetary policy measures, the Fed in particular, but also the ECB, have proven to be quite flexible compared to expectations some months ago. The latter speaks in favour of a clear focus on the inflation fighting mandate.

Moreover, in contrast to the time 50 years ago, central banks currently have at their disposal many more (market) signals with regard to inflation expectations. This is especially true on the (international) financial market. And there are no signs of a de-anchoring here yet. However, vigilance is called for and, if necessary, we expect clear signals — and or U-turns, as we have already seen in part from the Fed and ECB. We do not think that the leading global central banks have invested decades in anchoring inflation expectations to now simply give away this macroeconomically and socially important advancement.

There are also some moderating factors compared to the 1970s. For instance, the structure of the economy is different today than it was 50 years ago. The economy in the early 1970s was much more dominated by the industrial sector, which was used to accessing cheap and, above all, stable-priced oil. Today, however, the leading developed countries are certainly less dependent on crude oil prices and industrial sectors in general, which could imply lower growth losses and inflation spikes. Furthermore, the oil price shock is currently even more moderate than in the mid and late 1970s. Since then, entrepreneurs have had to learn to live with sharp price spikes, even if price spikes still hurt. In this respect, the current energy price shock is not the same as the energy price shock of yesteryear. Moreover, the wage-setting process has certainly changed permanently. Both the better understanding of price action on the labour side and the far more intense competitive situation on goods and labour markets reduced the extent of inflation-prolonging second-round effects or of upward price spirals. The importance of collectively agreed wages has also tended to decline in recent decades. Furthermore, we enter the current phase with inflation expectations still well anchored and moderate wage increases, especially in Europe.

However, there are also signs of increasing (structural) price pressure due to further shortages of other energy sources, more sustained price pressure in the agricultural sector, shortages to other input factors (industrial metals, fertilizers) and supply chain frictions. The latter being connected to the war in Ukraine and the state of economic warfare with Russia plus global supply chain strains. In this respect, medium-term inflation risks should not be underestimated, as we also express in our euro area inflation forecast for 2023. Here we see inflation remaining well above 3% in 2023, Moreover, some structurally price-driving factors could possibly intensify in the coming years (e.g. aging population in the established economies) and new factors have been added (shift from maximally price-efficient to more robust supply chains, costs of climate policies or ESG-preferences). However, as mentioned above, we do not see the leading central banks and also the ECB as "inflation-blind". In this respect, not everything necessarily points to a one-to-one repetition of the inflation and stagflation scenario as in the 1970s.

In principle, the ECB's looming monetary policy shift (or phasing our of "permanent crisis policies") is both appropriate and to be welcomed. However, it is also true that despite the ECB's cautious turnaround in monetary policy this year and perhaps further interest rate hikes next year, real interest rates in the meaning of money market rates or savings interest rates minus inflation may fall back to the level of the 1970s. To put it bluntly, we may not fall back into a 1970s scenario in macroeconomic terms, but for savers it may feel very similar. After the likely inflation peak in Europe in 2022 and 2023 with deeply negative real interest rates, we still do not expect real interest rates inside the euro area to inch well into positive territory and rather anticipate an environment as in 2009 to 2020 with moderately negative real interest rates. A return to positive real interest rates seems hardly possible in the euro area, where the scope for interest rate policy should be structurally more limited than in the USA.