The European Central Bank (ECB) has one term, which is to keep inflation close to 2%, which means that the current situation raises questions related to the credibility of the monetary authority. Moreover, signs are beginning to appear that rising inflation is already weighing on household budgets across the eurozone. This is something that, in itself, is already having a recessive effect (mitigated, to some extent, by the savings accumulated during the last pandemic years, according to economists).
But what keeps Christine Lagarde awake at night is that history shows that, as a rule, when central banks drag their feet on tackling inflation end up having to act, later, in an even more violent way. In other words, causing even deeper recessions.
Eurozone inflation should soon exceed 6%
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The inflation rate in the eurozone accelerated again in February, with prices rising 5.8% in equivalent terms, indicated Eurostat on Wednesday. The previous month, year-on-year inflation was 5.1%.
The magnitude of the acceleration by the European Statistical Office surprised many analysts, who had predicted slightly less intense inflation in February. Now it seems like “very likely to reach 6% in the coming months“, specifies the consulting firm Capital Economics.
If this expectation holds true, it means inflation will be three times the ECB’s 2% target – and “it seems likely that the rate will stay well above that target for a long time, probably ending the year 2022 in the region of 4%,” add economists from the London-based consultancy.
It is this impasse that was described by the Dutch team of analysts at Rabobank led by Richard McGuire in London. “Central bank officials basically need to choose which monetary policy mistake they prefer to make“, they say.
- “The first option is to raise interest rates and reduce demand current economy, to try to prevent short-term inflationary pressures (caused by problems on the to offer) change to long-term high inflation expectations. This could cause a relatively mild recession,” the analysts say.
- “The second option is not to raise interest rates and wait for problems in supply chains to improve, which could prevent inflation expectations from deteriorating. The danger of this option is that if the rate of price increases remains high and an inflationary wage spiral develops, then “toothpaste can come out of the tube”, i.e. the credibility of the ECB in the fight against inflation will be called into question — and it may take a significant crunch later to regain that credibility.
Between these two options, Rabobank’s belief is that “central banks tend to opt for the first”. This is clearly what the American Federal Reserve has decided to do, the central bank which confirmed on Wednesday that interest rates will go up in a few days. This is also the option taken by the Bank of England, which has already raised interest rates twice in recent months. As for the ECB, analysts’ expectations are more nuanced.
Interest rate derivatives markets no longer point to an ECB interest rate hike in the coming months, what would impact the Euribor. The change was quickas soon as Russian troops entered Ukraine and that several ECB personalities came to recognize that the impact of the war on the economy would be taken into account in the plans for withdrawing monetary stimulus.
In a few days, players in complex markets for forward interest rates started betting that the ECB won’t raise interest rates until March 2023. A few days earlier, these expectations fluctuated between September and December 2022.
“The war forced the rethink monetary policy, as far as the ECB is concerned,” ING bank commented in a note ahead of Thursday’s meeting. “Until recently, the main concern was related to the possible second-round effects of high inflation, potentially causing an inflationary wage spiral. Corn analysis changed rapidly: now the fear is that there may be effects ‘stagflationary‘ [inflação alta e crescimento baixo, em simultâneo]because the purchasing power of consumers is compressed by inflation,” add the ING analysts.
It is unclear to what extent these considerations entered into Putin’s calculations. But the war in Ukraine is adding to the risks of an economic slowdown and, at the same time, bringing more inflation through rising prices for oil, natural gas and other raw materials on which Europe depends. That’s why “too rapid a tightening of monetary policy, in this context, could produce even more negative effects in an economy already under pressure“says ING.