“The ECB must be an anchor of stability in the euro area now more than ever”

Marcel Fratzscher, President of the German Institute for Economic Research (DIW Berlin), comments on the results of today’s meeting of the European Central Bank (ECB):

The ECB has made a historic decision and one of its most significant of the past 20 years: The interest rate increase is larger than expected and the ECB has fundamentally changed its communication strategy. Now, the ECB’s most important task is to serve as an anchor of stability in the euro area to prevent an even deeper crisis. With this increase, the ECB has chosen the right middle path between a more restrictive monetary policy and more support for the most vulnerable euro area members. The ECB’s new monetary policy instrument, the Transmission Protection Instrument (TPI), is necessary to counteract the faster rise in interest rates over the coming months. 

The TPI, which is meant to ensure a symmetric transmission of monetary policy, is smart but risky, as it is unclear how this instrument will be used. Its conditionality is so low that it is unlikely to be able to provide the ECB with any de facto limits. Going forward, I fear a period of heightened volatility with increasing political pressure on the ECB. I expect ECB critics in Germany will turn to the Federal Constitutional Court immediately. Ultimately, the impending political conflict could seriously damage the ECB’s credibility. 

The ECB is facing a very difficult trade-off in pursuit of its price stability mandate. Even a very large interest rate increase would only have a small impact on inflation over the next 18 months. On the one hand, the ECB must raise rates to anchor inflation expectations and protect its credibility. If it fails to do so, it will take the ECB much longer and will be economically more painful to return to price stability. On the other hand, the ECB risks weakening the economy and contributing to a recession if it tightens monetary policy too early and too fast. Moreover, this would imply the risk of the ECB needing longer to reestablish price stability after a crisis. 

The economic situation in Germany and the euro area is extremely critical and the risks currently underestimated. I expect inflation will increase to ten percent and the economy will weaken further. Governments must not pass responsibility solely to the ECB to fight this economic crisis. What we need now is an expansionary fiscal policy with targeted support for low-income earners that focuses on strengthening investment to ensure the confidence of economic actors and combat a possible recession.