ECB President Christine Lagarde recently announced a quarter-point rise in the policy rate to 3.25%. This slowed the recent pace of tightening, but Lagarde told investors to expect further increases: The policy rate, she explained, was now in “restrictive territory” but not yet “sufficiently restrictive.” This was less than crystal clear. What, you might ask, was stopping the bank from making its policy sufficiently restrictive right away?
The answer is partly that a further squeeze is already in the pipeline, as lending declines thanks to tighter credit standards and lags in the effects of monetary policy. This will dampen demand regardless of further interest-rate changes. But the ECB is doubtless also concerned that raising rates more quickly would put too much stress on the region’s banks — and that mismanaged or unrecognized interest-rate risk would be as disruptive in Europe as it has been in the US.
Such fears aren’t unreasonable — but they still leave interest rates lower than they should be. The headline inflation rate has fallen from its peak of more than 10% but core inflation, which leaves out volatile food and energy prices, is proving much stickier. In April it was roughly unchanged, rising at a 5.6% clip — far faster than the bank’s 2% target. As a result, the policy rate is still firmly negative in real terms, and substantially lower than the equivalent US rate.
Many would argue that the risk of financial breakages makes it wise to err on the side of caution. But too much caution imposes risks of its own. If inflation stabilizes at more than twice the target rate, with expected wage growth settling in step, the further tightening required to get prices back on track will be more severe than if the problem were more promptly addressed. In that case, the banking and other stresses that the ECB hopes to avoid this year might well emerge later, only worse.
ECB officials shouldn’t be left to grapple with this by themselves. The euro area’s governments need to revisit their fiscal policies, acting in concert to ensure that they aren’t adding to the excessive demand that’s keeping inflation high. And they need to resume their protracted efforts, fruitless up to now, to unify their national banking systems to ensure that capital-market stresses don’t interact with fiscal weakness in a so-called doom loop of cascading financial crises.
The EU has long recognized the fundamental challenge to its long-tern economic stability — the mismatch between a single currency, on one hand, and uncoordinated fiscal and financial policies on the other. The ECB’s painful policy dilemma should refocus attention on this threat. It’s a problem Lagarde and her officials can’t solve by themselves.
More From Bloomberg Opinion:
• The ECB Finally Switches Off Autopilot Rate Mode: Marcus Ashworth
• Labor Market Trends Are Now the Fed’s Friend: Jonathan Levin
• Labor Market Tightness Is a Matter of Perspective: Claudia Sahm
The Editors are members of the Bloomberg Opinion editorial board.
More stories like this are available on bloomberg.com/opinion
