ECB Chairman

All advanced-country central banks are clearly concerned about inflation. If they were not, they would have not lifted rates at such a fast pace in such a short space of time. But their concern is not equal for the costs of high inflation are much greater for some than others.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks it is the ECB that potentially has the most to lose from high and persistent inflation for a couple of reasons. The first is that higher inflation in the euro zone tends to come with higher dispersion of inflation rates. When The European Economic and Monetary Union (EMU) started over 20 years ago, countries had to have inflation close to 2% to join the club. It meant that some traditionally high-inflation countries had to squeeze their inflation through the eye of a 2% needle to make it into EMU.

The fact that inflation did not re-accelerate after EMU entry was testament to the fact that pre-EMU policy discipline persisted after EMU stared and the fact that the ECB worked hard in the early years to keep inflation close to 2%. But fast-forward to today and inflation dispersion has increased significantly. Inflation dispersion clearly matters in a monetary because there’s no currency to devalue for those that lose competitiveness. This could force uncomfortable domestic adjustment on countries via much tighter fiscal policy, for instance.

Of course, much depends on whether inflation dispersion is temporary or long-lasting. If it is temporary there is not much reason to worry. It might also be of relatively limit ed concern at the moment given that the pre-EMU monetary policy disciplinarian – Germany’s Bundesbank - is actually presiding over a relatively high inflation rate compared to other EMU members, or at least those that joined initially in 1999.

However, if high inflation becomes persistent, and if Germany’s inflation performance improves relative to the others, we could find that competitive pressures within EMU intensify, perhaps even straining the whole system.

A second factor to bear in mind as well is the possible re-emergence of the so-called “doom loop” that so plagued the region during the 2010-12 euro zone debt crisis. This reflected the interplay between rising bond yields and pressure on domestic banks on account of their high holdings of local debt in many countries. The more the banks suffered the more the economy deteriorated and the worse the debt dynamics became.

In the current situation, bank sensitivity to domestic debt is still high in many countries and with the banking sector already feeling some stress, albeit more so in the US right now, there is a possibility that a new doom loop could develop if inflation stays high, persistent and diverse. It is worth remembering that when the global financial crisis happened in 2008/09 euro zone policymakers initially thought they were relatively immune. But weak growth and deteriorating fiscal metrics contributed to the 2010/12 debt crisis, meaning that the region was arguably the worst impacted by the ramifications of the financial crisis.

Coming back to today, the euro zone could prove to be the most vulnerable if high, persistent and diverse inflation leads to competitive pressures within the and more talk, as we saw in 2010/12 of countries being forced to leave EMU. Quite clearly, we are a very long way from this sort of pressure. As we’ve argued, it would probably take many years of significant inflation dispersion for competitive pressures to push any country or countries close to the edge of EMU expulsion or withdrawal.

However, in Mr. Steve Barrow’s view, this does not change the fact that it will be the ECB that proves the most hawkish of the central banks when it comes to eliminating inflation. This could clearly work to the benefit of the euro in the long haul as interest rate differentials should move in the euro’s favour, but these relatively high rates will only support the euro if they are not in place to cover for an inflation crisis in the region.