The Firefighter Arsonist’s Paradox – Central Bankers Are Now Worried About Inflation.
Yet inflation is the product of their ultra-accommodating monetary policies.
Within the European Central Bank, there are a few hawks who are constantly pushing Christine Lagarde to take real action to fight the risk of inflation. Among these hawks is Klaas Knot, the governor of the Dutch Central Bank (DNB). While the ECB has been practicing negative interest rates for several years now, Knot has always been among those who have fought against this monetary policy, which he considered too lax.
After having been in the minority for a long time, he is now going with the flow of history. With the great return of inflation, the European Central Bank (ECB) announced on Thursday, June 9, 2022, that it would raise its interest rate twice, in July and September 2022.
Knot is among those who believe that we should go as fast as possible.
In July 2022, the ECB has already announced that its deposit rate, currently at -0.5%, will increase by 25 basis points. But, in September 2022, it leaves itself flexibility, and Mr. Knot wants to accelerate:
“If conditions remain the same as they are today, we will have to raise the rate by more than 25 basis points. The next level is to raise 50 basis points, but our options are not necessarily limited to that.”
For Knot, it's clear that the increase will have to be more than 25 basis points. This leaves the door open for a hike to 75 basis points, which is scary for all financial market investors.
After that, the ECB will have two more meetings before the end of 2022, in October and December, and Mr. Knot intends to use them to continue raising rates:
“It all depends on the data and the economic environment, but there is a real probability that rates will continue to rise in October and December.”
This should lead to an ECB rate of 0.75% or even 1%. A level that has not been reached since January 2011!
When Klaas Knot is asked if this is his wish, this is what he simply says:
“This is what the financial markets are currently predicting.”
He doesn't say it openly, but then he intends to continue the rate hike into 2023. The markets are expecting a 1.5% rate in the first half of 2022, and Knot seems comfortable with that idea.
The ECB is changing its tune, and more and more central bankers believe it is urgent to act
For the Dutch central banker, it is urgent to act. Inflation reached 8.1% in the eurozone in May 2022, and the spiral must be stopped: “We are very worried about inflation”. Mr. Knot acknowledges that most of the price increase comes from the surge in energy prices, caused first by the exit from the COVID-19 pandemic and then by the war in Ukraine, all of which are phenomena that interest rates cannot do much about.
But the phenomenon, initially considered transitory by the ECB, is now spreading to the entire economy:
“We are particularly concerned that inflation is spreading to the entire consumer basket. Now, 75% of the prices we measure are rising by more than 2%. Core inflation, excluding energy and food, is now 3.8%, which is double our 2% inflation target.”
Doesn't the rate hike risk plunging the eurozone into recession?
“No, I don't think so. The eurozone economy is clearly going to suffer from the conflict in Ukraine, but its level coming out of the pandemic was excellent.”
While soaring energy prices are of course reducing household purchasing power, the DNB governor points out that other parts of the economy are still growing:
“The tourist season this summer is going to be the first without restrictions since the pandemic. Just look at the chaotic situation at Amsterdam's Schiphol airport and other airports. In the Netherlands, not to mention an overheated economy, there are some signs that are visible in the real estate market and the job market, among others.”
Real estate prices are up 20%, and the country is, de facto, at full employment (3.2% unemployment rate).
The problem is that the ECB has to juggle an economy like the Netherlands with others that are much less dynamic, including Italy and Spain. After the ECB announced the interest rate hike, financial markets became tense, and the Italian ten-year government bond rate jumped, now at 3.9%, the highest since January 2014.
“Of course the economies are different, but inflation is above the 2% target everywhere, core inflation is high everywhere... And there are other countries where inflation is even higher. Look at Estonia, which is up to 20%.”
Isn't there a risk of a return of a eurozone crisis, fragmentation of countries with investors preferring Germany, deemed safe, to Italy or Spain, or even France?
Mr. Knot assures that the ECB will be ready to intervene:
“If the market threatens the homogeneity of monetary transmission, it is clearly within our mandate to respond.”
Knot recalls that in March 2020, at the start of the COVID-19 pandemic, a brief financial panic took hold of the markets, which attacked the eurozone:
“In five days, we carried out the so-called 'PEPP' pandemic program, an asset purchase program that today amounts to 1,700 billion euros. Two or three weeks later, the spreads between eurozone countries were back to levels we were comfortable with.”
For Knot, the normalization of monetary policy and the exit from negative rates signals the end of a parenthesis that was not healthy for the economy:
“I'm glad we're finally leaving negative rates. We all know that low rates for a long time have negative consequences. It causes a whole series of distortions in the economy and financial exuberance, in the real estate market, cryptos, the stock market ... It's good to finally get out of it.”
Final Thoughts
As you can see, while Knot has always been on the hawkish side at the ECB, the ECB has been leaning more on the dove side in recent years, which is no stranger to the current situation. To hear all these central bankers say today that they are afraid of this persistent high inflation is a sobering thought and reminds us of the paradox of the pyromaniac fireman.
For if central bankers are now trying to fight this high inflation that is spreading to the economy at great speed, we should not forget that they are at the root of this high inflation. They are the ones who printed more than 10,000 billion dollars out of thin air in the eighteen months following the COVID-19 pandemic, just as they are the ones who pursued an ultra-accommodating monetary policy.
The current consequences stem from their recent past actions, and it is a safe bet that as soon as they succeed in bringing down and then stabilizing this inflation, they will fall back into the old ways that the flaws of the current monetary and financial system allow them to do.
With central bankers, mistakes never teach lessons. Let's hope that it will be different this time, but I fear that it will not.
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