It is now clear that the European Central Bank views higher interest rates as the right response to rising oil prices. As a result, the ECB risks painting itself into a corner, for the logic behind this week’s interest-rate hike implies that more increases will follow – a series of policy mistakes that will cost the Eurozone economies heavily.
Despite statements to the contrary, no central bank, including the ECB, can simply focus on inflation and ignore what happens to economic activity. Suppose, for the sake of argument, that stabilizing prices came at the cost of a 30% unemployment rate. Surely nobody would want that.
The ECB’s defenders would say that such an outcome is purely hypothetical – and irrelevant – for there is no conflict between stabilizing inflation and sustaining the appropriate level of economic activity. Price stability, according to this view, reduces uncertainty, thereby enabling firms and individuals to take the right decisions, so it is good, not bad, for economic activity.
This argument is true – most of the time. But when an economy faces a major adverse shock, such as a sharp increase in oil prices, then the twin goals of stabilizing inflation and maintaining economic activity conflict, and the central bank’s job becomes more difficult.