On the eve of the ECB meeting, the analysis by the two Romer validates the ECB’s option of raising interest rates. In other words, if the shock to the Eurozone persists, then Christine Lagarde’s team will have to act quickly and decisively. They cannot hesitate because the cost of inflation is high and long-lasting.
Several remarks
1- The inflationary shock, the price of oil, is external in nature, independent of the internal situation of the Eurozone. It is not the result of an internal imbalance.
During the first oil shock, the shock was external, and the central bank that prevented inflation from developing was the most restrictive. In France, the United States, and England, the objective was to absorb the shock since it originated externally, and consequently, the economy should not be constrained. The Bundesbank took the opposite approach.
Consequence
A – The German inflation rate was much lower. Between the last quarter of 1973 and the last quarter of 1983, the average annual inflation rate was 11.2% in France, 8.2% in the United States, and 13.4% in the United Kingdom. In Germany, the figure was only 4.6%.
B- This limited the inflation premium driven by long-term interest rates. The consequence is a faster recovery in Germany than in the other three countries mentioned.
C- Furthermore, no shock was needed in Germany to get out of the long period of inflation of the 1970s. No Paul Volcker with Fed rates at 20%, nor a turn towards austerity like in France with Jacques Delors in the spring of 1983.
D- An inflationary shock creates internal imbalances that monetary policy must combat. That is its role. If it were limited to external shocks, it would not be very active.
2- The argument that weak growth will be further penalized by restrictive monetary policy is understandable. However, this was also the reason given in the mid-1970s to accommodate the oil shock in France, the United States, and Great Britain, with the well-known results.
Due to the nature of the changes occurring since the pandemic, the world will be more inflationary. Politics, heightened competition driven by technology, shortages, and energy distribution have created friction in international trade.
These will result in adjustments to value chains, international trade weakened by straits, uneven productivity, and price movements to facilitate collective adaptations.
The energy shock will almost certainly be more persistent than we imagine or hope. The risk of inflation will remain, and that is why central banks will continue to play a crucial role in managing the economic cycle and inflation.
