A new study has shed light on how trust in the European Central Bank (ECB) influences firms' inflation expectations amid rising public debt in the euro area. The research, based on a survey of around 7,000 German firms, reveals that nearly half of the respondents believe the ECB may not raise interest rates sufficiently to control inflation due to fiscal pressures from other euro-area governments. This belief is significantly more prevalent among firms that distrust the ECB, with about 70% of the least-trusting firms expecting the ECB to hold back on rate hikes, compared to fewer than 40% among the most-trusting firms.
The study also conducted a randomized experiment where firms were presented with different projections of debt-to-GDP ratios for France, Italy, and Spain. Firms shown a pessimistic scenario, where debt rises to 140% of GDP, expected higher inflation compared to those shown an optimistic scenario. Notably, the effects on inflation expectations were driven entirely by firms with below-median trust in the ECB. These firms raised their expected inflation by about 0.5 percentage points for the short term and 1.4 percentage points for the medium term, while firms with above-median trust barely reacted.
The research suggests that the ECB's ability to control inflation depends heavily on the public's trust in its commitment to price stability. The findings highlight the risk of fiscal dominance, where inflation expectations become unanchored due to concerns about government finances. The study also found that news about German public debt did not significantly alter inflation expectations, indicating that firms regard debt as inflationary only when it is issued by other euro-area member states that they expect the ECB to accommodate.
The study underscores the importance of maintaining trust in central banks to ensure effective monetary policy. As public debt remains high in several large euro area economies, the ECB's challenge is not just economic but also one of preserving the public's confidence in its ability to deliver on its mandate.