Bundesbank President Jens Weidmann says central banks shouldn’t become harnessed to fiscal policy or financial markets. “One of the secrets of success for an independent monetary policy has always been recognising and respecting one’s own limitations,” he explained in a speech at the European Banking Congress in Frankfurt am Main. Central banks are undoubtedly powerful institutions, he remarked, but it would certainly be wrong to overestimate their capabilities. “The Eurosystem was granted independence in order to achieve its primary objective of price stability. The more broadly we interpret our mandate, the more we run the risk of becoming entangled with politics and overburdening ourselves with too many tasks,” Mr Weidmann cautioned.

Monetary policy relies on solid fiscal policy

For monetary policy to safeguard price stability in the long term, it relies on solid fiscal policy, he continued. It is therefore vital that all Member States of the euro area forge a path to sound public finances after the crisis.

He explained that for a stability-oriented monetary policy in the long run, three things have to come together: “First, a fiscal policy framework within the monetary union that ensures sound public finances; second, central banks that won’t become harnessed to fiscal policy or financial markets; and third, a narrow interpretation of our mandate.” Hence, the upcoming reform of the EU fiscal rules should draw on the lessons of the past. “We need a credible and more binding set of rules. To that end, these rules must become simpler and more transparent.”

Lagarde: Monetary policy has to be patient and persistent

Another topic covered by the European Banking Congress was the recent strong increase in inflation and the question of how long this will persist. Measured in terms of the Harmonised Index of Consumer Prices (HICP), euro area inflation in October came to 4.1%, well up on the ECB’s 2% target in the medium term.

ECB President Christine Lagarde used her speech to stress that today, inflation is largely being pushed up by the exceptional circumstances created by the pandemic. The central bank “must not rush into a premature tightening when faced with passing or supply-driven inflation shocks,” Ms Lagarde reasoned, adding: “At a time when purchasing power is already being squeezed by higher energy and fuel bills, an undue tightening would represent an unwarranted headwind for the recovery.” Monetary policy must therefore remain patient and persistent, while being alert to any possible destabilising dynamics emerging.

Weidmann: Don’t ignore the risk of too high inflation

The Bundesbank President expressed his concern about current price developments in the euro area, noting that “the elevated inflation rates will probably take longer than previously projected to recede again”. Indeed, supply shortages may wear on for some time. Beyond that, he said, the price outlook is exceptionally uncertain. “Higher inflation expectations and higher wage growth could strengthen price pressures in the medium term [and] the fallout from the pandemic could have a marked impact on the inflation setting.”

“We should not ignore the risk of too high inflation and instead remain watchful,” he said. Given the considerable uncertainty about the inflation outlook, monetary policy should not commit to its current very expansionary stance for too long. “If required to safeguard price stability, monetary policy as a whole will have to be normalised,” he also emphasised. “This should be crystal clear to everyone – to financial markets as well as to governments, whose funding costs may rise.”