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Prof. Olivier Blanchard

“The Fed and ECB could overshoot their target.”

Prof. Olivier Blanchard, economist at the Massachusetts Institute of Technology (MIT) closely monitors inflation and its development in Europe and the USA. He presented an analysis of the very different picture on either side of the Atlantic to investors in the Large Hall at Frankfurt’s Alte Oper.

He explained that core inflation is the problem in the USA, where an overheating labour market is driving wages higher, which is not the case in the eurozone. Conversely, the challenge in Europe is headline inflation, as the main price drivers in this region are commodity and energy prices, unlike in the USA. As a result, headline inflation in the USA is likely to ease over the next few months, while core inflation excluding energy and food prices will remain excessive. The reverse is true in the eurozone, where headline inflation is set to remain high while core inflation poses less of a problem. As demand in the USA remains extremely robust, the US Federal Reserve (Fed) has a lot of work to do to slow down the economy and thus inflation. In the eurozone, however, demand is highly likely to weaken as rising import prices for energy in particular have an adverse impact on purchasing power. This means that the ECB, unlike the Fed, does not need to reduce demand any further.

But what does all this mean for interest rates? While the Fed will be forced to keep rates high, the ECB needs to make sure it does not raise interest rates too sharply if at all possible. In doing so, it would do well to remember the rate hike it carried out as a reaction to rising energy prices in autumn 2008. This move was largely regarded as a mistake, and the ECB will try to ensure that it does not repeat it.

Blanchard added that he would not be surprised if the ECB loses some of its enthusiasm for interest rate rises once inflation reaches 2.5%. On the other hand, there is a definite risk that the Fed and ECB will overshoot their targets. While they know that interest rate policy only takes effect after a delay, they must also leave investors in no doubt about their determination to resolve the issue, otherwise this could impact inflation expectations and cause them to rise. According to Blanchard, “central banks need to watch that like a hawk and react accordingly”.

Blanchard takes a nuanced to relaxed view of rising government debt levels, asserting that governments should not shy away from increasing debt if there are good reasons to do so, such as helping companies with rising energy prices. “Let’s be realistic – we won’t be getting back to 60% debt ratios anyway.”

Interview with Prof. Olivier Blanchard

In an interview, Prof. Olivier Blanchard discusses where inflation might go from here, the tarnished reputation of the European Central Bank, and the future of the euro – could it become a soft currency?