Frankfurt The European Central Bank (ECB) faces one of its most difficult meetings on March 10th. The deepening crisis in Russia is exacerbating a situation that was already complicated enough: inflation in the euro area has risen by more than 5 percent, and data such as producer prices for industrial goods suggest that this is still the case.
According to the Federal Statistical Office, German producer prices in January, mainly driven by expensive energy, were 25 percent above the level of the same month last year, which was the highest jump since 1949. Jörg Krämer, chief economist at Commerzbank, is therefore expecting until autumn for Germany with inflation of at least five percent. The danger of a wage-price spiral is growing.
Criticism of the ECB and its President Christine Lagarde, sometimes with clearly populist undertones, is also increasing in Germany. The exchange of blows between economists on Twitter, for example between the economist Volker Wieland and DIW boss Marcel Fratzscher, is getting rougher. Wieland belongs more to the monetary policy “hawks”, the proponents of a hard monetary policy. Fratzscher belongs to the “doves” camp, which tend to have a loose monetary policy.
One thing is certain: the markets and many consumers are expecting the change in monetary policy. At the same time, however, the question arises as to whether it is advisable to withdraw monetary policy support in a situation characterized by war and sanctions.
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And even without the conflict between Russia and Ukraine, the ECB is in a more difficult situation than, for example, the US Federal Reserve (Fed), because here in Europe, in addition to excessive inflation, slipping into low growth and deflation could still be an issue in the medium term , as the economist Ricardo Reis of the London School of Economics warns.
According to the latest statements by members of the Governing Council of the ECB, the central bank is likely to end its monthly bond purchases of currently 20 billion euros net in a few months. Markets currently appear to be assuming that the ECB will hike rates this year, but it is questionable whether a binding decision will be made at the March meeting.
In any case, the central bank only wants to raise interest rates when the above-mentioned bond purchase program, known by the abbreviation APP, has been set to zero, i.e. only expiring securities are replaced. The stop of the PEPP emergency program for March has already been decided.
The decisive interest rate is currently the one for commercial bank deposits at the ECB, which is minus 0.5 percent and is also responsible for the negative interest on bank customers’ accounts. The official interest rate, which is charged for short-term loans, is zero, but this is of little importance at the moment because the banks are more likely to have too much than too little liquidity.
Russia not included yet
Until recently, not only the markets, but also most economists only marginally considered the Russian crisis and its possible consequences in their calculations. A few days ago, Ricardo Reis confirmed that the ECB was facing “extremely difficult” decisions.
In a virtual event at Princeton University in the US, Reis argued that for the ECB there is still not only an inflation risk, but also the risk of falling back into a situation of low inflation and low growth, i.e. the usual weak scenario before the corona pandemic. The more the war-related threats intensify, the more the possible economic weakness is likely to become an issue, while at the same time inflation, which is already being driven primarily by energy prices, will initially continue to run hot.
The economist derives his scenarios from an analysis of the capital markets.
(Photo: Sergio Moraes)
Reis, who is known for his quantitative studies, does not simply express his personal opinion, but derives his scenarios from an analysis of the capital markets. Above all, he focuses on option transactions that make it clear what expectations investors have.
In a nutshell, his finding is that the Fed started the change in monetary policy about half a year too late, but there is no sign of a significant delay at the ECB. The base case for the Fed is still inflation moderation without a recession. The possibility of a halt to inflation plus a recession in the USA and then the risk of inflation exceeding four percent for a longer period of time follow with much less probability.
For the ECB, the picture is even more complicated: A mild outcome is still possible in the euro area, but the market data still indicate the risk of excessive inflation and the danger of a slide into the opposite direction, a deflationary trend. In other words, at least the direction is clear for the Fed, but for the ECB it is even more important to strike the right balance.
Lagarde creates unity
The market analysis of rice is partly supported by economic arguments. Admittedly, the supporters of a continued soft ECB policy have recently become somewhat quieter and the supporters of the monetary policy swing, which is to be expected anyway, are becoming louder.
But Erik Nielsen, for example, chief adviser to the major Italian bank Unicredit, points out that inflation in the euro area has so far been driven primarily by energy prices, which the ECB can hardly influence. Above all, he argues with the expectations, which are still moderate, unlike in the USA: “I would remind you that the inflation forecasts largely point to values below two percent for 2023 and 2024.”
Although Nielsen is critical of the ECB’s swing, in his study he pays tribute to Lagarde for having apparently managed to bring the Governing Council of the ECB to a fairly unified line. Statements by ECB chief economist Philip Lane, whom critics have so far seen as a “super dove”, speak in favor of this. In a recent speech, he also underscored the danger of inflation becoming entrenched. And he noted that it is by no means certain that it will return to weak pre-crisis levels in the longer term.
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