Interest rates and the impossible balancing act facing the ECB

ECB president Christine Lagarde has intensified her warnings about the risks of inflation — hinting that interest rates may have to increase more rapidly that already indicated. The ECB will certainly raise rates at its next meeting on July 21st, with analysts still expecting a quarter point rise though by no means ruling out a half point hike. EU inflation figures for June due next week will be vital.

And Lagarde’s warning that more “determined” action might be needed in the months ahead is a clear warning shot for borrowers — a second rate increase in September now looks a nailed-on certainty, and might well be a half point increase. For now, markets expect ECB rates to be around 2.5 per cent moving towards the end of next year — the deposit rate is current minus 0.5 per cent. In a world of uncertainty, these kind of estimates based on market prices can only be treated as tentative. But in the midst of the unpredictability, the ECB must act. And it faces two really tricky, interlinked, balancing acts.

1. Inflation versus recession

Lagarde was speaking at the ECB’s policy conference in Sintra, Portugal, which also heard a string of warnings from other central bankers about the twin risks of inflation and recession. The problem for central banks, including the ECB, is that inflation requires higher interest rates, but recession normally points to lower rates. While the ECB mandate, unlike that of the US Federal Reserve Board, does not extend to wider economic considerations beyond controlling inflation, a slowdown in growth, by reducing demand, normally increases unemployment, lowers spending and thus reduces inflationary pressures.

The problem this time around is that the main cause of inflation is coming from supply factors in key markets such as energy, food and messed up supply chains and not from overheating economic growth. Higher interest rates don’t help here. But central banks will move interest rates higher because they now fear that inflation is spreading into other areas, affecting wages and, crucially, altering the expectations of businesses and consumers about the future rate of price growth. And when people expect higher inflation, it tends to become a self-fulfilling prophesy.

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The risk, of course, in a time of threats to economic growth is that higher interest rates worsen the slowdown in economic growth or even help to push economies into recession. There is always a “price” to controlling inflation — the argument is that not doing so leads to an even greater economic cost down the line. But when the weapon of higher interest rates does not relate directly to the cause of the inflationary surge, then the risk of collateral economic damage — slower growth and higher unemployment — is even greater.

Lagarde has tried to walk the line, saying the ECB would move “gradually” but can take a more determined approach if needed. For now the ECB does not expect a recession in Europe. But if there is one, or growth shows very sharply perhaps due to further problems in energy markets, then the question is whether this will slow the upward march in interest rates.

In his latest Project Syndicate article, economist Nouriel Roubini argues that central banks are facing the worst of both worlds — so-called “stagflation”, meaning high inflation and stagnant growth — and may “wimp out” in terms of the scale of interest rate increases, implicitly accepting a higher inflation rate. In a particularly pessimistic outlook, he says that in his view we are heading for a combination of 1970s-style stagflation and 2008-style debt crises — that is, a stagflationary debt crisis. Most forecasters are not this gloomy, but recessionary fears are certainly now on the increase. And market volatility lies ahead.

2. Protecting the periphery

The second balancing act for the ECB is acting to prevent tensions in European sovereign debt markets. Already there have been pressures on Italian government debt, with the gap between Italian and core German rates widening sharply — to two percentage points, And while borrowing costs remain low by historical standards, there are fears of volatility ahead if markets fear that slow growth and rising borrowing will hamper the ability of countries to service their debt piles.

All EU sovereign debt markets had been protected by ECB buying of government debt, which increased during the pandemic, effectively providing a backstop for private investors and holding interest rates down. Now, as part of the “normalisation” of policy, new purchases of debt are being stopped. With the stabilisers off and big uncertainties in markets, tensions are brewing.

The ECB has promised to develop a new “instrument” to help protect peripheral countries. This would involve it buying debt of peripheral countries to help keep interest rates down and dissuade investors from targeting countries as they did during the financial crisis. However, agreeing how this will work is not easy.

The ECB can — and will — reinvest some of the proceeds from its existing holdings of State debt, but the amounts involved here are unlikely to be sufficient. Another policy instrument — Outright Monetary Transactions (OMT) — was designed in the midst of the financial crisis but never used. It allows the ECB to buy sovereign bonds, but requires countries to be receiving assistance from EU bailout funds and to follow strict policy conditions.

For now, the ECB will be looking for something more flexible. But northern European countries will insist on conditions in terms of budget policies which countries seeking help must follow. And for the southern countries such conditions would, of course, be political dynamite. Italy, for example, is heading for a general election next summer.

So the ECB’s ability to act to support peripheral countries may be constrained. The Republic is not immediately in the spotlight here, but the country does have a high national debt level and is vulnerable to a global downturn.

The ECB thus faces two really difficult balancing acts in the months ahead. Much will depend on the course of the war in Ukraine. But confronted by a combination of high inflation and slow growth, it is facing a really significant test in trying to find a middle route through.

[ Cliff Taylor: How did the Republic become the EU’s second most expensive country? ]