The European Central Bank (ECB) has made the Federal Reserve’s (Fed) job harder. After dangerously ignoring inflation for months, Fed Chairman Jerome Powell has at last adopted an anti-inflationary policy stance.
The Fed will gradually unwind its former practice of directly buying securities on financial markets—what central bankers refer to as “quantitative easing.” Sales from the hoard of securities built up in past buying will siphon inflationary liquidity from financial markets and the economy. Policymakers have also begun what looks like a long string of interest rate hikes.
Many see these steps as too little, too late. Still, the ECB’s decision to take no anti-inflationary action will make the Fed’s fight that much harder and promises to inflict price pressures in both Europe and the United States for longer than otherwise.
In the face of European inflation reports almost as severe as in the United States, ECB President Christine Lagarde has all but refused to take action. She has talked about ending the bank’s quantitative easing program, perhaps not until September. Interest rate increases, she has stated, will wait until late this year, if then.
Lagarde explains her lack of action by drawing two distinctions to the American situation. Europe, she asserts, is less far along in its post-pandemic recovery than America, and its economy is much more vulnerable to the sanctions imposed on Russia. These are indisputable facts but still are no reason to ignore inflationary pressures.
The Fed’s lack of aggressiveness and the ECB’s outright passivity are especially distressing because today’s inflation—on both sides of the Atlantic—stems from more fundamental and stubborn sources than policymakers want to admit. The official line in both Washington and Brussels is that the inflation is the result of post-pandemic supply chain problems and the fallout from the war in Ukraine, especially the sanctions placed on Russia.
Undoubtedly, the supply chain difficulties and the sanctions have contributed to inflationary pressures. Still, an exclusive focus on them ignores the deeper, more fundamental roots stemming from years of misguided fiscal and monetary policies that neither central bank can rectify easily or quickly.
For over a decade now, Washington and governments throughout the European Union (EU) have pursued extremely stimulative fiscal postures that have created extremely wide budget deficits. Each continent has faced a succession of crises that seemed at each stage to require such policies, but the pattern over this long time has nonetheless created economic imbalances.
Worse, from an inflation standpoint, the authorities on both continents have used extremely expansive monetary policies to finance these fiscal policies. The Fed in the United States, for example, has used new money creation to purchase some $5 trillion in government debt over the past decade, $3 trillion in just the last couple of years. This is the modern equivalent of financing government by running the printing press—a classic prescription for inflation.
This kind of underlying inflation problem would impose a tough fight on the combined efforts of both central banks, but the ECB’s inaction will burden the Fed tremendously. Rising interest rates only in the United States and direct withdrawals of liquidity from financial markets will tend to lure funds from Europe. Such movements are already evident in the dollar’s rise in foreign exchange markets. It has risen some 12 percent against the euro in just the last four months and is now higher than in the last six years.
This drawing off some of the inflationary fuel in Europe will do some of Lagarde’s work for her. At the same time, it will make the Fed’s efforts to draw down the inflationary liquidity in American markets that much more challenging. Effectively, the Fed will be conducting the anti-inflation fight for both central banks. That burden will call for bolder action from Powell and his colleagues than if the ECB were cooperating. It will also prolong the inflation fight for longer than would otherwise be necessary.
The Fed has already made its job more difficult by wasting a year denying inflation when it could and should have been pursuing policies to stem price pressures. That has allowed an inflationary psychology to embed itself into the situation, which, the experience of the last great inflation in the 1970s and 1980s shows, can make the anti-inflation fight that much more difficult. Now Lagarde and the ECB have added to the difficulties. The only thing to conclude is that inflationary pressures will trouble both Americans and Europeans for some time to come.
