Like many Germans, Otmar Issing is alarmed by the surge in inflation to 40-year highs in his country and worried by the “misguided” response of the European Central Bank. But, as one of the founding fathers of the euro, Issing’s complaints carry more weight than most of his countrymen.
The ECB’s first chief economist when it was created in 1998 said the central bank was suffering from a “misdiagnosis” of the factors behind the surge in prices, having “lived in a fantasy” that downplayed the danger of inflation spiralling out of control.
“The ECB has contributed massively to this trap in which it is now caught because we are heading towards the risk of a stagflationary environment,” said the 86-year-old, who is credited with shaping the central bank’s use of money supply measures to decide interest rate policy.
His criticism that the ECB is being too slow to raise interest rates underscores the fractious debate in Germany and much of the 19-country euro area about how fast it should reverse eight years of ultra-loose monetary policy — including negative rates and €4.9tn of bond purchases.
After struggling to lift inflation up to its 2 per cent target for the past decade, the ECB is now confronting the opposite problem. Consumer prices have been shooting upwards as the European economy rebounds from the deep recession caused by the pandemic. In March, eurozone inflation hit a new record of 7.5 per cent.
“Inflation was a sleeping dragon; this dragon has now awoken,” said Issing, speaking to the Financial Times at his home in Würzburg.
The ECB’s governing council meets this week in Frankfurt to discuss whether to speed up a plan for gradually withdrawing its stimulus by ending net bond-buying in the third quarter. Some of its policymakers argued at its meeting last month for an earlier end to its bond purchases to prepare the ground for raising interest rates this summer.
Many central banks, including the US Federal Reserve and the Bank of England, have already stopped buying bonds and started raising interest rates.
“It is obvious the ECB is late to react, while the Fed might be even more behind the curve,” said Issing, who has been president of the Centre for Financial Studies at Goethe University in Frankfurt since leaving the ECB in 2006.
His former colleagues at the ECB predict that many of the factors pushing up the price of energy, food and other commodities will fade quickly from the end of this year, helping inflation to fall back below 2 per cent by 2024.
But Issing said this ignored the risk that the pandemic and Russia’s invasion of Ukraine will keep inflation higher by reversing 30 years of globalisation as trade tensions rise, companies make supply chains more resilient and Europe accelerates its switch away from fossil fuels.
“The ECB relied on its forecasting model and this model cannot give the right signals because it is based on the past and cyclical experience — and the pandemic did not cause a cyclical downturn,” said Issing.
“You need a much broader approach to explaining inflation in a time of structural changes. If you have a misdiagnosis, of course, you have a misguided policy.”
Other German financial figures have stepped up their criticism of the ECB. Christian Sewing, chief executive of Deutsche Bank, Germany’s biggest lender, said last week that soaring inflation was “poison for the stability of our economy and society” and it was “urgent” for the ECB to act.
Axel Weber, the outgoing chair of UBS and former head of Germany’s central bank, told financial newspaper Handelsblatt it was “incomprehensible” the ECB was taking so long to turn its policy around. Bild Zeitung, the country’s top-selling tabloid paper, has started referring to ECB president Christine Lagarde as “Madame Inflation”.
Germans have a deep-seated fear of inflation, which Issing said “goes back to the hyperinflation in the 1920s and currency reform in the 1940s . . . It is almost entrenched in the genes of the public”. But he said the concerns were “not just the Germans being pathological about inflation — you can observe this in all countries”.
Several ECB policymakers — including chief economist Philip Lane — have said they can do little to address external factors driving up energy prices, while they fear raising interest rates too soon could precipitate a severe downturn — especially if war in Ukraine disrupts the flow of oil and gas from Russia to Europe.
Both Lagarde and Lane have said the ECB could even introduce a “new instrument” to support countries facing a sharp increase in borrowing costs as rates rise. Their staff are already working on such a “crisis tool” to make targeted purchases of sovereign or corporate bonds if needed.
Issing agreed now was “not the time to raise interest rates to elevated levels”. But he said the ECB had already kept its stimulus in place for too long, which was “very hard to defend” given the rebound in growth and inflation while unemployment has fallen to a record low.
“The ECB lived in the fantasy of continuing this policy without any negative consequences,” he said. “They would be in a better, or at least a less bad, situation if they had started to normalise policy before — the war should not distract from this fact.”
The prospect for a “stagflationary” situation of rising inflation and slowing growth is “the worst combination” for a central bank, said Issing, who contrasted monetary policymakers’ responses to the two oil shocks of the 1970s.
“The Bundesbank tried to control inflation and the consequence was moderate inflation and a mild recession,” said Issing, who joined the German central bank in 1990. But “the Fed waited too long” and the US had “double-digit inflation and a deep, deep recession”.