(Bloomberg) — Governments’ efforts to ease the energy crisis risk forcing the European Central Bank to raise interest rates more aggressively as it battles record inflation, according to Governing Council member Pierre Wunsch.
It’s already “reasonable” for the ECB to lift borrowing costs to 3% from 0.75% now to tame prices, the Belgian central bank chief said in an interview in Washington. A “subsidy war” where states distribute aid to energy-intensive firms would add to the pressure, he said.
“The biggest worry is having monetary policy trying to get inflation under control and fiscal policy doing ever more to support people,” said Wunsch, one of the ECB’s more hawkish officials. “There’s a real risk of a policy mismatch, and the result of that will be higher rates — because we have to do our job — as well as higher deficits.”
The remarks underscore the challenges of coordinating monetary and fiscal policy as economic growth sinks and inflation soars. The issue was front and center as global policy makers convened for the International Monetary Fund’s annual meetings, with the turmoil in the UK showing what can happen when the policies of governments and central banks clash.
While the situation in the 19-nation euro zone isn’t as strained, ECB officials have been urging for months that support measures for households and businesses are targeted, to avoid further stoking inflation that — at 10% — is already five times the official target.
Governments are still setting aside hundreds of billions of euros for natural gas price caps and other initiatives, with some calling for Europe-wide tools to backstop such steps and avoid an economic meltdown.
Wunsch said a technical recession — commonly defined as two consecutive quarters of shrinking output — is now the “base case” in Europe, though that in itself won’t be sufficient to “get inflation under control.”
“Market expectations now are that we’ll take interest rates to 3%,” he said. “We should consider it as a possibility.”
As borrowing costs are lifted, policy makers shouldn’t get spooked if “some pockets of vulnerabilities” emerge in markets. Not every such episode would warrant an activation of the institution’s new anti-fragmentation tool.
“We should have some tolerance for flirting with some crises because you are not going to prevent everything before you see where markets are going,” Wunsch said.
At the same time, officials should press ahead with winding down the ECB’s €5 trillion ($4.9 trillion) in government-debt holdings — accumulated during recent crises including the pandemic.
“With 10% inflation, there is no reason why we would keep such a big balance sheet,” Wunsch said. “We should start as soon as possible and with a relatively low volume so that we can test market absorption capacity and then increase volumes as we get comfortable with the fact that markets can absorb the reduction.”
Removing stimulus is all the more important because conventional assumptions that inflation will eventually revert back to the 2% goal may no longer hold true, he said.
Wage growth of about 5% will probably become “the new normal” for a few years as workers attempt to recoup some of the losses they incurred over the past year — one of many trends not reflected in models used to gauge future price growth.
That means the first ECB forecasts for 2025 that will come out in December — a key input into policy decisions in normal times — will have an information value “close to zero.”
What’s more certain is that further appreciation of the US currency will aggravate the inflation outlook.
“The stronger the dollar the higher the pressure on us,” Wunsch said. “Our monetary policy, like it or not, is influenced by what’s taking place in the US.”