Bundesbank President Joachim Nagel has once again advocated making a timely start on normalising policy rates in the euro area. The risk of acting too late is increasing notably, he said at a conference in Eltville am Rhein, which the Bundesbank co-hosted with the National Association for Business Economics (NABE). “As inflation in the euro area continues to run high, we need to act,” Mr Nagel urged. “And if both the incoming data and our new projection confirm this view in June, I will advocate a first step [towards] normalising ECB (European Central Bank) interest rates in July.”

Delaying monetary policy turnaround is risky

In the current situation, it is more important than ever that the Eurosystem central banks act in time, the Bundesbank President said, noting that their action should be foreseeable, gradual, and data-dependent. “Delaying a monetary policy turnaround is a risky strategy. The more inflationary pressures spread, the greater the need for a very strong and abrupt interest rate hike,” Mr Nagel argued. Amongst other things, he pointed out, this may place excessive strain on firms and households and could lead to vulnerabilities in the financial system.

Inflation risks are clearly tilted to the upside

In his speech, Mr Nagel also addressed the war in Ukraine and its impact on price developments in Europe. He believes the war is unlikely to bring about major new inflation dynamics on its own. “But it may clearly accelerate pre-existing tendencies in both the short and the long run, as exemplified in energy markets and international trade,” he added.

Mr Nagel pointed to the fact that inflation was running high even before the Russian invasion began, and the main reason for this was the pandemic and the attendant restrictions. In March 2022, the inflation rate as measured by the Harmonised Index of Consumer Prices (HICP) came to 7.6% in Germany and 7.4% in the euro area. According to initial estimates by the Federal Statistical Office, it continued to climb in April, reaching 7.8% in Germany and, according to Eurostat, 7.5% in the euro area.

The Russian invasion of Ukraine has added to the pre-existing price pressures, both directly and indirectly, Mr Nagel said. The war is putting more upward pressure on energy prices, he continued, which could in turn push up the prices of other products. He also mentioned that the sanctions on Russia are distorting various supply chains, as both Russia and Ukraine produce a number of goods needed in the retail trade and at upstream stages of production.

Energy embargo could hit German economy where it hurts

The Bundesbank President outlined how a further escalation of the conflict – combined with tougher sanctions – could weigh on the German economy, at least in the short term. This was demonstrated by a model-based scenario analysis run by the Bundesbank, which assumed that energy imports from Russia would stop abruptly. “In this scenario, the German economy might even slide into recession, with real output contracting by up to 2% in 2022,” said Mr Nagel. It goes without saying that this scenario is subject to considerable uncertainty, he noted, and recent reports suggest that Germany’s dependence on energy imports from Russia has already been reduced markedly. “Bearing this in mind, the outcome of an embargo could also be less severe.”

Inflation expectations significantly higher

When looking at the development of medium-term inflation expectations in Germany, the Bundesbank President expressed some concern. According to recent results of a Bundesbank survey, the five-year-ahead inflation expectations of individuals in Germany had risen to 4.8% in March. And in April, firms had lifted their expectations to 4.5%. “All this suggests that higher inflation rates will prevail in the near future and that inflation expectations could become less anchored,” Mr Nagel concluded.