I keep thinking of the ‘sacrifice ratio’ mentioned in the speech that ECB director Isabel Schnabel made at the end of August. This ‘sacrifice ratio’ is central bank speak for ‘we are going to raise interest rates to bring down inflation and you will be making a sacrifice in the form of a loss of purchasing power and jobs.’ Recently, a new step towards that sacrifice was taken by means of a large interest rate hike. Why is no one wondering whether that is normal?

Central bankers are congratulating themselves for having kept inflation under control for decades. Following the stagflation of the 1970s, interest rates were raised sharply at the end of the decade by Fed-chairman Volcker. The Great Moderation that followed was indeed a period of low inflation. But was that due to the efforts of central bankers?

Globalisation, falling commodity and product prices, innovation and - not forgetting - liberalisation of product and labour markets made an important contribution to those low inflation rates. Moreover, automatic price compensation was skilfully deleted from collective labour agreements. During almost the entire period, workers in most advanced economies were unable to claim their share of the productivity gains. Price pressure diminished to such an extent that in the last 15 years central bankers completely failed at getting inflation up to the target level of 2%. The medicine that they used - extreme liquidity - did not fuel inflation, but instead fuelled wealth inequality by creating asset price bubbles.

The real economy has undeniably, and that is exactly what Schnabel is saying, become less sensitive to monetary policy. Labour market tightness no longer automatically means higher wages. And because the economy is becoming more service-based and virtualised, growth has become less dependent on large-scale capital expenditure. A very low stabilising interest rate (in jargon: equilibrium interest rate) limits the room for effective central banking policies. 

There are plenty of reasons to be very careful about raising interest rates in these uncertain times. Because the automatisms of the 1970s that accelerated the wage spiral have been broken, there is less reason to be worried about a full-force stagflation scenario. Flexible labour markets will sooner correct than in the seventies. Inflation expectations, as this is what it is all about, are currently still anchored reasonably firmly at a little above 2%.

Since the major source of inflation is a supply side shock in energy and resource prices, it would now be the right moment to invest in alternatives: renewable energy, circular business models. But higher interest rates makes these investments less attractive, resulting in a delay in building up supply and ‘higher for longer’ inflation. But what is most worrisome, debt positions – both public and private – have reached unprecedented levels. Increasing interest rates too soon can destabilise the financial system.

However, the ECB is drawing exactly the opposite conclusion: if our policy is having only a limited impact, then we should do more now. Have more people lose their jobs, saddle employers with higher interest rates and make it completely impossible for first-time buyers to finance a house, rather than proceed carefully. A flight forward, with an urgent call on society's willingness to self-sacrifice.

And that really makes me wonder: is our economic system not completely broken if millions of people will need to live in poverty to reach price stability?

This is an translation of Hans Stegeman's column in Het Financieele Dagblad, published13 September 2022.