Why the ECB is in no hurry to fight inflation

The euro has lost a lot of ground versus other major currencies as the European Central Bank (ECB) is taking a very dovish stance even compared to the usually dovish Bank of England.

As expected, a German has the difficult task of being a lone hawk amid doves: Isabel Schnabel, member of the ECB’s Governing Board, recently warned that the central bank has consistently been wrong in its inflation forecasts.  

“Since the start of the year, we – just as other forecasters – have repeatedly underestimated inflation in our central scenario, and we have done so by a significant margin. Elevated inflation is now expected to last for longer than we previously thought,” Schnabel said in a speech for a virtual Goldman Sachs event.

Indeed, inflation in the euro area was 4.1% in November, up from 3.4% in October and compared with the ECB’s 2% target.

So, will the ECB tighten monetary policy to defend its target? No. That target has been shifted to “medium-term” inflation, specifically to give the central bank more leeway to ignore spikes in prices that it believes to be temporary.

Why is the ECB so dovish? One explanation can be found in its own Financial Stability Review: house prices in the eurozone have gone through the roof. In the second quarter of 2021, house price growth in the euro area was the fastest since 2005, at 7.3%.

During the Covid-19 pandemic, people’s incomes have been supported by fiscal measures, while they managed to “obtain financing for house purchase at record low interest rates,” the review itself shows.

“Despite the recovery in residential construction, labour shortages, global supply chain bottlenecks and input price increases are weighing on the construction sector’s ability to expand housing supply, which is putting upward pressure on house prices.”

The degree of debt that households in the euro area take on, as well as the overvaluation of residential real estate (RRE) are increasing, as house prices and debt are overtaking income growth. This adds to worries about a debt-fuelled housing bubble, the review also shows.

House price growth in the eurozone
Source: ECB

“In particular, households with variable rate mortgages or shorter fixed-rate periods on their mortgages are exposed to an unexpected rise in interest rates, which could adversely affect their ability to service their debt,” according to the ECB’s Financial Stability Review.

Tightening monetary policy and raising interest rates would crash the eurozone housing market and the whole economy, just like they would in the UK. No wonder, then, that the ECB is in no hurry to fight inflation.