A steep upward curve in a coordinate system can be a good sign. But not always. When Isabel Schnabel took to the podium last week at Hachenburg Castle, where the Deutsche Bundesbank’s University of Applied Sciences is based, to talk to students about the causes of inflation in the euro area and provide an outlook for the coming months and years, she provided convincing evidence of this in a wealth of charts mapping inflation rates, commodity prices, negotiated wages and more. A few of these certainly give cause for concern. But others provide grounds for hope.

© Thorsten Schneider

“This topic is on everyone's mind. It is of huge relevance to society,” said Schnabel, who joined the Executive Board of the European Central Bank two years ago. In July, consumer prices rose by an annual rate of 8.9%. “These are figures,” said Schnabel, “that are intolerably high. Just a few months ago, this would have been unimaginable.” Schnabel, who was a longstanding member of the German Council of Economic Experts, is held in high regard by the general public for her strong opinions. According to Erich Keller, Rector of the Bundesbank’s University of Applied Sciences, she is “one of very few experts of such calibre on the ECB’s monetary policy decision-making process.” In Hachenburg, too, she made no attempt to sugarcoat the economic situation.

Why prices are rising

To understand the origins of the high inflation, Schnabel told the around 100 students and lecturers in attendance, it was worth looking back at 2020, the year the pandemic began. The swift economic recovery following the huge slump triggered by the first, far-reaching lockdown had been interrupted repeatedly by further waves of the pandemic, she pointed out. “There was a growing imbalance between supply and demand, not least because of disruptions to global supply chains. Companies were no longer able to supply goods fast enough,” said Schnabel, explaining that this had caused prices to rise. “Many people were surprised to see these problems lasting far longer than originally thought.”

Schnabel emphasised that the ECB was far from alone in repeatedly underestimating inflation in its forecasts. And the war in Ukraine had further exacerbated many of the economic problems that already existed, she added. “The euro area is now particularly affected by its dependence on Russian energy imports,” Schnabel said, commenting that the weakness of the euro against the US dollar was making the situation even more difficult. However, alongside the higher energy prices, additional factors had long since been contributing to inflationary pressures, she emphasised. According to Schnabel, the fact that the curves mapping inflation still showed a sharp rise even when the costs of energy and food were excluded was “particularly worrying."

Rising interest rate expectations of financial markets

Yet Schnabel rejects the well-publicised accusations levelled at the ECB that it is not tackling this development forcefully enough. “The financial market data show very clearly that this is not true,” she said, pointing out that interest rate expectations on the financial markets had recently risen sharply, partly because the ECB was far from inactive. The ECB had already announced last December that the net asset purchases under the pandemic emergency purchase programme (PEPP) would be brought to an end, before deciding to discontinue purchases under the asset purchase programme (APP) a few months later. “In July, the ECB then raised interest rates for the first time in eleven years.” As a result, the markets expected inflation to fall back towards the target of 2% in the long term, Schnabel said. However, she stressed that the risk of inflation expectations becoming de-anchored needed to be monitored closely.
In the short term, however, forecasts remained rather downbeat, including for economic growth. “The outlook for the coming winter is rather gloomy, especially in Germany,” Schnabel commented, although she added that there were at least some factors bolstering the economy. She pointed out that the labour market was doing surprisingly well, with unemployment rates at a historical low. “There is a shortage of labour across all skill levels." 

Difficult task for monetary policy

The pent-up demand in areas such as travel after more than two years of the pandemic was also leading to positive developments in certain sectors of the economy, especially the services sector, Schnabel said, naming fiscal policy as the third supporting factor. “In the current environment, safeguarding price stability remains a particularly difficult task for monetary policy.” “We will do everything in our power,” she emphasised, adding that there was still plenty more that could be done in view of the further interest rate increases already expected.