Central banks face credibility problems as inflation rises

Credibility problems

Rising inflation is increasingly becoming a topic of conversation in Europe. In the eurozone, inflation reached 4.1% in October, well above the 2% target, while the ECB is doing nothing about it. However, the central banks believe that the inflation is only temporary.

Due to the corona crisis, there are now disruptions in the supply chains. The central bank expects these problems resolve after the pandemic. But the ECB and other major central banks do say that inflation is higher than they previously thought and that it will sustain for a longer period of time. And that causes credibility problems not only with the public, but also on the financial markets.

Three possible scenarios

According to Pieterse-Bloem, this indicates a widening gap between the average opinion of the market and the central banks. ‘The market sees more structural structural elements of inflation. This would force central banks to raise interest rates sooner than they currently claim. You also see in those markets that the interest rate increase is being pushed forward. Although this is more of a problem for the Federal Reserve than for the ECB.’

According to Pieterse-Bloem, three scenarios are now possible: 'Either the markets are right and the central banks have to raise interest rates sooner than expected. Or the central banks could be right, in which case the markets will have to revert to their positions.' But a third scenario is also possible. Then the central banks listen to the markets, raise interest rates, but if inflation is temporary, a costly policy error has been made. This has happened before, which is why central banks are waiting to see which way the wind is blowing.’

‘There are many uncertainties in the economy', Pieterse-Bloem says. ‘We don't know how long the disruptions in the supply chains will last and the virus could flare up again.’