The ECB struggles with an impossible situation

Many believe the ECB is too timid to rein in inflation, which hit double digits in nine of 19 eurozone countries in June. “The very gradual and cautious normalization process that the ECB started at the end of last year was simply too slow and too late,” says Carsten Brzeski, head of macro research at Dutch bank ING.

Some members of the ECB’s rate-setting governing council — notably those in the Baltics where inflation is close to 20% — broke ranks to call for a more aggressive half-point rate hike on Thursday .

“It’s like antibiotics, it doesn’t help if you take them in September if you’re sick now,” says one of the most hawkish ECB board members. “Interest rates are our medicine and the timing and size of the dosage is of the utmost importance.”

So far, the eurozone economy has been relatively resilient, with retail sales and industrial production remaining above year-ago levels, while the lifting of COVID-19 restrictions has boosted travel and summer tourism.

The main thing keeping ECB officials awake at night is fear that Russia is militarizing its energy exports.

But economists expect high prices to erode the purchasing power of European households and weigh on industrial production as companies cut output.

“If you are a business and gas is an essential input for production, you will probably [have started to] are already producing less in anticipation of possible supply disruptions,” says Spyros Andreopoulos, senior European economist at French bank BNP Paribas. “We are already seeing signs that this is starting to happen.”

Economists at Germany’s Deutsche Bank estimate that soaring prices for imported energy and food will add 400 billion euros ($592 billion) to the euro zone’s trade balance this year. This is already undermining consumer and business confidence, pointing to a likely slowdown later this year, especially as the US and Chinese economies are already slowing sharply.

But the main thing keeping top ECB officials awake at night is fear that Russia will weaponize its energy exports to gain an advantage in its invasion of Ukraine by increasing economic pain for Europe.

“The dependence of European countries – and the eurozone is an example – on external supplies from enemies, has had a major impact on prices,” Lagarde said in June.

“This could contribute to inflation directly, if it leads to further increases in energy costs, or indirectly, if a higher level of energy prices makes part of the production unprofitable and leads to a lasting loss. of
economic capacity.

Sven Jari Stehn, chief European economist at US investment bank Goldman Sachs, said eurozone inflation is expected to peak above 10% in September. But if Russian gas flows stop completely, he warns that “the risks are skewed towards a sharp contraction and even higher inflation”, adding that the euro zone economy would continue to contract until the second quarter. next year under these circumstances.

“It’s a nightmare scenario for economic policymakers,” says Lars Feld, professor of economics at Albert Ludwigs University in Freiburg, who advises the German finance minister.

“It’s more difficult than in the debt crisis of 2012, when we had a clear choice between monetary policy or fiscal policy solutions, but now the two are much less clear.”

Protect citizens

As long as inflation continues to rise, the ECB is likely to keep raising rates even if the economy begins to nose dive, while higher borrowing costs will make it harder for governments to spend more to protect their citizens from the soaring cost of living. This fuels political tensions across Europe.

Public anger over soaring energy and food prices played a key role in fracturing Draghi’s ruling coalition in Italy, leading him to offer his resignation – only for the see refused by the president. High inflation has also eroded support for French President Emmanuel Macron and contributed to his failure to win a parliamentary majority in June’s elections.

“I fear political instability in Europe, in Italy and, of course, in France,” said Vítor Constancio, former vice-president of the ECB, now professor of economics at the University of Navarre in Madrid. “If Macron has problems approving the budget next year, there could be elections in France and the prospect of Italian elections is also a complicating factor, no doubt.”

Borrowing costs are already rising faster for heavily indebted southern European countries like Italy than for some of their fiscally stronger northern counterparts, reminiscent of the demons of the debt crisis sovereign power that almost tore the eurozone apart ten years ago.

It’s an uncomfortable reminder for the ECB that, unlike the Fed or the Bank of England, it sets monetary policy for 19 countries, each with its own budget and, crucially, its own bond market. This makes the single currency vulnerable to a divergence in borrowing costs between countries, which can test the sustainability of national debt levels.

“Of course you still have this general risk of a crisis on the periphery of the eurozone playing out in the background,” says Dirk Schumacher, head of macroeconomic research Europe at French bank Natixis. “It’s something the Fed doesn’t have to deal with.”

In response, the ECB is expected to announce that it will tackle any unwarranted divergence in a country’s bond yields by buying its bonds using a new scheme it calls the transmission protection mechanism.

Unlike the yield curve control policy of Japan’s central bank, which buys as many bonds as necessary to cap the country’s borrowing costs at a fixed level, the ECB is unlikely to target a bond yield specific for each country and will instead use its judgment on when to intervene.

This has raised concerns, particularly in more frugal countries such as Germany and the Netherlands, that the ECB will encourage fiscal profligacy among member states and stray into the “monetary financing” of governments – the printing of money by a central bank to support a country’s economy. budget – which is contrary to the EU Treaty.

“It is impossible to distinguish empirically what is political risk from market speculation,” says Feld, the former chairman of the German council of economic experts. “Market pricing will have a disciplining effect on policy decisions and we should let it work.”

Limit energy consumption

The growing anxiety in EU capitals about how best to respond to the punitive combination of rising prices and collapsing growth is clear. Without predicting a recession, the European Commission last week lowered its growth estimates and sharply raised its inflation forecast, which is now expected to reach 7.6% in the euro zone this year and remain at twice the ECB target of 2% in 2023.

The committee’s draft proposals, due out this week, would limit energy use in public buildings as they scramble to find ways to conserve gas amid threats from Moscow.

Officials are candid about the economic headwinds facing Europe. Klaus Regling, head of the European Stability Mechanism’s bailout fund, warned last week that while the economy and consumers come under “massive pressure”, markets face greater volatility given the combination higher inflation and higher interest rates – something many traders have never experienced in their professional lives.

This does not mean that we are facing a new “euro crisis”, insists Regling – a sentiment shared by Paschal Donohoe, the Eurogroup’s president, who has repeatedly underlined the more solid institutional structure enjoyed by the euro area today compared to ten years ago.

Nonetheless, the dangers of a sudden loss of market confidence weigh heavily on officials’ planning – with Italy at the center of their concerns.

The Eurogroup last week discussed setting up an informal working group of officials to monitor markets during the summer break – a time when low liquidity and short-staffed trading floors can lead to disruptive movements in bond yields and stock markets. The group will adapt to the vagaries of emerging markets and have the power to summon decision-makers if problems arise, according to people familiar with the plans.

The search for closer coordination between the institutions and the Member States responds to a wider concern of the Ministries of Finance, namely the risk of disjointed or contradictory action by different Member States which ends up eroding, rather than reinforcing , market confidence.

Emerging from a meeting in Brussels last Tuesday, Sigrid Kaag, the Dutch finance minister, stressed the need for unity between the capitals of the monetary union, warning: “Everyone is struggling with the same problems , and if a recession is looming…I think we have to meet and converge around the same choices”.

The 19 eurozone finance ministers say they have already agreed not to stimulate demand with additional borrowing next year, to ensure they do not fuel further inflationary pressures.

Maintaining a clear and agreed line, however, will be much easier said than done. Italy is at the center of member states’ concerns, given the risk that Rome will fall behind on its reform commitments or fail to rein in government borrowing.

Giuseppe Conte, the leader of the Five Star Movement, withdrew his support for Draghi’s national unity government last week, throwing the ruling coalition into chaos. Conte accused the Prime Minister of doing too little to help families reeling from soaring energy and food prices.

If the government were to collapse, it would raise doubts about Rome’s ability to pass a budget in November, stoking fears in northern capitals that Italy will once again emerge as a dangerous weak point in the armor of the euro zone.

Asked about the situation in Rome, Paolo Gentiloni, the European Commissioner for the Economy, stressed the importance of not adding political jolts in the face of the feverish world situation.

“In these troubled waters – war, high inflation, energy risks, geopolitical tensions – stability is a value in itself. Now is the time to stick together, to stick together,” he said.

After the COVID-19 pandemic hit in 2020, plunging much of Europe into a post-war record recession, Lagarde said there were “no limits” to the commitment of the central bank to the euro. This commitment may be about to be tested again.

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