Cliff Taylor: By autumn, the ECB will be in the eye of a storm

The European Central Bank is in a bind. It is the same one facing central banks across the world. But because Europe’s proximity to Ukraine leaves it more exposed to the economic fallout of the war, the ECB’s problem is greater. It has to persuade us all that increasing interest rates is a good idea at a time of likely recession and a cost-of-living squeeze; that taking yet more money out of people’s pockets is the right way to address rising inflation. It is going to be a hard sell.

The ECB president, Christine Lagarde, this week wrapped the argument in the head-wrecking jargon favoured by today’s central banking classes. The bank wants to “normalise” interest rates, she told us, which to you and me means it wants them to head a good deal higher.

Like the rest of us, the ECB really has no idea what is going to happen next. Its “base case” — what it thinks most likely to happen — is that the euro zone will slow, but will avoid recession. Many other forecasters are more pessimistic. If Russian gas supplies are cut completely — and the European Commission thinks they will be — then big economies such as Germany will certainly drag the euro zone into recession. The cost-of-living crisis is already threatening this anyway. Confidence is ebbing fast. A slowdown is certain and a recession is possible.

Into this arena steps the ECB, with the first interest rate hike in 11 years. From a central banking point of view it had no option, with euro zone inflation close to 9 per cent. It had to react, if only to persuade people it is not asleep at the wheel. But rapid economic growth is not what is driving inflation; instead it is soaring energy prices and the knock-on impact of the war and the messy exit from Covid. Central banks don’t have the tool to combat this. They can only hope that higher interest rates somehow stop higher inflation becoming permanent. But at what cost?

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In a series of tweets in response to the ECB move Olivier Blanchard, former chief economist at the International Monetary Fund and an influential voice, summed up the problems of today’s central bankers. When inflation comes from an overheating economy, convincing people that the economy needs to slow down and unemployment has to rise to control inflation “is hard but at least the logic can be explained”, he tweeted. But “when inflation comes from an increase in commodity and energy prices, convincing workers that unemployment has to increase to control inflation is even harder”. They will ask “Why should I lose my job because Putin invaded Ukraine?”

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And there is really no answer to this, beyond pointing out the dangers of high inflation becoming embedded. Higher energy prices are leaving all energy importing countries, including Ireland, a lot worse off, creating huge pressures. These will now be added to by interest rate hikes. Politicians, including Irish ones, are fond of telling central bankers to do their jobs and control inflation. Now they will have to deal with the consequences. This could all come to a head in September when the ECB looks set to announce another half point rate hike. By then it will be clear that euro zone growth is falling away. This will put the ECB right in the eye of the storm, accused of pushing the euro zone economy into recession.

Wrapped up in Lagarde’s talk of “normalising” interest rates is the possibility of ECB interest rates, which are 0.5 per cent after the latest hike, reaching 1.25 or 1.5 per cent by the end of the year or early 2023. A recession, which in itself could cut demand and help bring down inflation, might well force the ECB to slow the pace of increases, or even to stall completely. That said, if the choice is between recession and further interest rate hikes, it is not the cheeriest of prospects.

The other factor which could slow interest rate rises is trouble on the markets. The ECB announced a new policy on Thursday allowing it to step in to support countries under market pressure by buying their debt. Italy may need this help, with its cost of borrowing already rising and its government collapsing. But the ECB has put terms and conditions on its support. First it will only step in when it feels pressure is “unwarranted” — in other words not justified by the way a country is behaving or by its underlying economic position. And second, the country must be seen to be pursuing what are judged to be suitable economic and budget policies. As Italy is heading for a general election, this conditionality will be controversial — with echoes of the financial crisis — and in any case the country may be judged to be in breach of some of the financial terms and conditions. In short, there could be trouble ahead.

There are real question marks here about the ECB giving itself the authority to judge who does and does not qualify for help. The central bank is careful to frame this as merely a way of ensuring its policies affect all euro zone countries in the same way — that is its ostensible and technical rationale, but it is impossible to avoid this being essentially political. And the ECB governing council is an unelected group — comprised mostly of central bankers and economists — with a predictably traditional worldview. Arguably it is being left to pick up too many of the pieces because populist politicians find it hard to do so.

In today’s world, of course, central bankers are all powerful. During the pandemic, budget policy and monetary policy essentially merged as central banks stepped in to ensure that governments could borrow cheaply to spend the vast sums needed to support economic growth. But stepping out now — withdrawing these supports and the super low interest rates — is a lot more difficult. From being the heroes during Covid-19, central banks now risk becoming the villains of the piece. At least the politicians will have someone to blame.