Inflation is not always and everywhere a monetary phenomenon

The 21st century has already posed many challenges for the European Central Bank (ECB). In 2008,  the Great Financial Crisis broke out, followed by the Euro crisis in 2010  (Heylen, 2020, pp. 312-390). During these crises, the ECB’s  conventional monetary policy measures did not sufficiently stimulate the economy. Short-term interest rates reached their zero lower bound, necessitating additional stimulus. The central bank resorted to unconventional monetary policies including quantitative easing (QE) which involved the large-scale buying of government bonds in secondary markets in order to lower long-term interest rates. However, QE failed to promote aggregate demand, instead increasing inflation (Van Doorslaer & Vermeiren, 2022). This was due to a lack of coordination between the ECB’s monetary and fiscal policies. Restrictive fiscal policies such as public spending cuts and tax increases countered stimulative monetary policies. In fact, persistently low real interest rates and inflation even raised the prospect of secular stagnation.  The need for more effective coordination between legislative and executive powers and central banks is therefore pressing. 

In recent years, the ECB has also faced other crises. Several economists sometimes refer to it  as a “Polycrisis” (Hobelsberger, Kok & Mongelli, 2022). In 2020, the COVID-19 crisis provided the ideal context for such  coordination. After all, the central bank was already involved in the monetary financing of  rapidly rising fiscal deficits. Governments incurred these debts to support real incomes. In  addition, climate change poses an existential challenge for future ECB policy. The Central Bank is adapting its monetary policy framework to help transition to a low-carbon economy. 

The persistent undershooting of the ECB’s inflation target, also known as lowflation, and the  perception that inflation appears less affected by economic fluctuations prompted the ECB to  review its monetary policy (Berkmen, Moghadam & Teja, 2014). In July 2021, the central bank published its Strategy Review (European Central Bank, 2021). This review formulated a new definition of price stability, prompting the ECB to pursue a symmetrical inflation target of 2% in contrast to its previous target rate of just under 2%. Henceforth, both positive and negative deviations from this will be considered equally undesirable. In addition, the review commits the ECB “to an ambitious climate related action plan to further include climate change considerations in its monetary policy framework.”  

However, this review was written in an environment of low inflation. Russia’s invasion of Ukraine pulled inflation up to highs not seen since the stagflation crisis of the 1970s (Blom, Hasekamp & Sleijpen, 2022). The  ECB’s mandate requires it to focus on ensuring low and stable inflation. Nevertheless, it will  be argued below why such a monetary policy is pernicious to combat today’s challenges. In addition, it will also consider how the current high inflation rate should give the ECB an incentive to further green monetary policy. 

‘Fossilflation’ 

The title refers to a quote by renowned US economist Milton Friedman (1994): “Inflation is always  and everywhere a monetary phenomenon”. According to him, price levels increase  when too much money is pumped into the economy due to excessive credit demand. From this reasoning, low interest rates and unconventional measures such as QE and the Pandemic  Emergency Purchase Programme (PEPP) will lead to inflation. In December 2022, the price level in Europe grew by 9.2% (inflation.eu, 2023). However, this price rise is not due to expansionary monetary policies by the ECB but mostly because of external shocks. Skyrocketing inflation is not caused by ECB policy decisions but rather our economy’s dependence on Russian fossil fuels (Lagarde, 2022). 

Prices already started to rise after the COVID-19 outbreak (De Sloover, Jonckheere & Stevens, 2022). Disrupted supply chains created an imbalance between supply and demand. The war in Ukraine, specifically Putin turning off the gas tap, pushed prices even higher in 2022. The scarcity in the supply of gas and oil caused spikes in energy costs. However, energy is not the only “weapon” Russia’s president has used to put pressure on Ukraine and the West. After the invasion, Russia blocked Ukrainian ports, thereby preventing grain shipments by Ukraine via the Black Sea (European Council, 2023). As Russia and Ukraine are both major grain exporters, this impediment to their exports created a global shortage of grain and drove up food prices therefore compounding the inflationary pressures caused by high energy prices. 

The ECB recognises that dependence on fossil fuels poses a threat to macroeconomic stability, specifically inflation, leading to the term ‘fossilflation’ (Thiagarajan, Lacaille, Mocuta & Im, 2022). Climate change will affect the dynamics of supply and demand in the future and so will have major implications for inflation and growth. The current scarcity in oil and gas should therefore accelerate the transition to green energy. However, the ECB’s current monetary policy complicates the necessary investments for this. 

‘Greenflation’ 

After taking unconventional measures during the Euro Crisis and the COVID-19 pandemic, the central bank aimed to normalise its monetary policy again (Privitera, 2022). Therefore, the ECB announced that it would stop buying bonds through the Pandemic Emergency Purchase Programme (PEPP) and QE. In addition, it would also raise interest rates to normal levels after they had been historically low for years. Because inflation has risen so sharply, the ECB  had to raise its interest rates much earlier than it had expected (European Central Bank, 2022i). In addition, it also  announced a tapering of corporate bond holdings (quantitative tightening). This has ended  the era of “cheap money” and has fuelled the green finance gap (Campiglio, 2016). The green energy transition requires investment in low-carbon and green energy infrastructure which are more capital-intensive than fossil fuel technologies and thus become more expensive when interest rates rise. By raising interest rates and tightening access to loans, the ECB’s policies risk hampering investments necessary to transition away from fossil fuels by the public and private sectors (Van Doorslaer & Vermeiren, 2022). 

The transition from a “dirty” to a green economy will initially be inflationary, but it is an investment in the future. Furthermore, this ‘greenflation’ will be temporary (Schnabel, 2022). The price level will naturally stabilise again once the infrastructure for a carbon neutral economy has been implemented. Europe will be able to benefit from renewable and cheaper energy. Therefore, the ECB raising interest rates is the wrong reaction to current circumstances as it stifles the long-term benefits of a transition to a low-carbon economy. 

Central bank independence 

Current macroeconomic challenges raise the question among several economists and academics whether central bank independence (CBI) should be reviewed. As Ben Bernanke (p. 4) (former Federal Reserve chairman) said in 2017: “The inflation-centric rationale for CBI looks a bit outdated in a world in which inflation and nominal interest rates are too low, rather than too high; and in which politicians have criticised central banks for being too expansionary rather than not expansionary enough. Indeed, the same logic holds that CBI is necessary to avoid excess inflation that can be turned on its head, to imply that CBI is a barrier to the fiscal-monetary coordination needed to combat deflation.”

Monetary policy was transferred from political institutions to an independent central bank in  the 1992 Maastricht Treaty. This avoids monetary policy being subject to changing political power relations (Wagner, 1986). This is because it is undesirable for politically controlled bodies to  pursue their inflationary tendency of time-inconsistent monetary policy. Politicians want to be re-elected so they spend a lot of money in the run-up to the elections. This leads to high budget deficits and would induce high volatility in inflation and economic development. Therefore, the ECB’s main objective is to safeguard price stability in the Eurozone. Thus, it is important for a central  bank to safeguard its independence. This theoretical legitimisation of CBI is dominant in the  economic sciences and the policy world.  

However, in the present critical circumstances, the ECB is bumping up against the limits of its mandate. The ‘green monetary policy dilemma’ is pressing: “On the one hand, there  is an urgency for central banks to contribute to keeping global warming below 2°C by closing  the green finance gap and maintaining financial stability; on the other hand, the dilemma is  concerned with the question on how to preserve the central bank’s mandate and independence  while ’leaning’ against climate-related risks” (D’orazia & Popayan, 2020).  

Currently, the ECB is practising ‘market fixing’ (Baer, Campiglio & Deyris, 2021). It is going to encourage private investors to  voluntarily reduce their exposure to “dirty” assets by disclosing climate-related risks and  conducting stress tests. This indirect redistribution of capital is part of the ECB’s  macroprudential policy. In the future, the central bank could move towards market shaping by, for instance, forcing banks to hold more capital and reserves against green assets and the reverse for dirty assets. This is a promotional measure that would lead to a direct redistribution of capital. However, such actions and decisions would go against the ECB’s claimed neutrality and political independence.

However, this reasoning can also be reversed. Indeed, the ECB’s “secondary” mandate requires it to  support the general economic policies of the European Union (EU) (van ‘t Klooster & De Boer, 2022). If the EU is committed to pursuing the climate goals in the Paris Agreement, surely ECB policies should also contribute to a low-carbon economy?  

The ECB currently applies the principle of market neutrality in bond purchases (Van Doorslaer & Vermeiren, 2022). This means  that for corporate bond purchases, the central bank will mimic the structure of the markets.  However, this neutrality is an illusion as these programmes favour dirty assets. Large carbon intensive companies are more dependent on external financing and thus have a relatively  higher share of corporate bonds. Market neutrality is nowhere to be found in EU treaties or ECB statutes. The way ECB bond purchases are distributed by sector may hinder the transition to a greener economy. Market neutrality can therefore be seen as conflicting with the ECB’s secondary  mandate. 

In conclusion, if the current high inflation proves anything, it is that the ECB should not actively  pursue low and stable inflation. Normalising monetary policy will slow down the crucial transition to a climate neutral economy and will minimally impact inflation caused by external shocks. Rather, current inflation rates highlight the problematic nature of our dependence on fossil fuels, a dependence that will only become more difficult as climate change unfolds. Two decades in crisis should have made it clear to our central bankers that abnormal measures sometimes have to be taken in abnormal circumstances. Monetary policy that boosts the green energy transition will bring many short-term costs but also greater long-term benefits. Therefore, an understanding of the situation should allow the ECB to act on its secondary mandate and ensure long-term price stability.

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