The European central bank is currently asked to face sensitive monetary issues, as the pandemic first and the war in Ukraine soon after triggered, among other things, serious problems for the European economy. We will probably have to carry on with some of their consequences for a long time.
Let’s start from the two main events of this summer. First of all, the end in July of the PEPP (Pandemic Emergency Purchase Program)[1]: the purchase of government bonds outside the capital key rule (i.e. with no respect of proportionality with the States shares of the ECB capital). This extraordinary program (1,850 billion euros) was launched to deal with the economic consequences of the pandemic and its end was expected. The second event, however, was not: we refer to the increase of the Eurozone interest rates[2]. In Frankfurt the decision has been taken to rise them of 25 basis points, for the moment, as other increases are expected in September. That’s the consequence of the high inflation rate that, on contrary of the initial forecasts, is turning out to be less temporary than initially believed.
What kind of effect will these events trigger on the European economy? What trends can we expect in the coming months?
Hard to say. Let’s try to summarize some points.
- The long period of general economic growth, low interest rates and price stability, that followed the 2008 and 2011 crises, is over.
- The assumption, held for many months by both the US Federal Reserve and the European Central Bank, that post-pandemic inflation was temporary[3] has proved incorrect.
- In Europe, the rebound of the economy following the fall caused by the Coronavirus seems to be almost cancelled (or anyway greatly reduced) by the consequences of the Russian invasion of Ukraine. The European Commission’s cautious spring forecast[4] will likely be revised in autumn.
- Unlike the USA, where FED is acting significant rises in interest rates, in European countries it appears more difficult to counter the rise in prices with monetary policy alone: European inflation is not mainly caused by an excess of demand, it is rather generated on the costs side (exceptional rises in energy and food products costs). It is therefore exogenous, meaning that it is produced by bottlenecks in supply chains, war in Ukraine, lockdown in China. Difficult to fight it (only) by levering on interest rates.
- The way forward was in any case obliged to ECB. Unthinkable to remain inactive in front of an average eurozone inflation of 8%[5].
- Cutting-off the expansionary monetary policy has a risk, however. The spectre is called recession. The European central bank has very few tools to control inflation without restrain consumption and investments: do both things at the same time is quite impossible, as this would require fiscal actions that are out of Frankfurt’s mandate, of course.
- Christine Lagarde’s position seems to be in line with German “orthodox” thinking, meaning that she thinks it is not to monetary authorities to contain spreads. That is correct, by the way, insofar this does not fall within the ECB’s tasks (it is the States that should do something, improving their fundamentals and launching adequate fiscal policies). However, great differences in bond yields between euro area member States jeopardizes the very existence of the single currency, and the protection of the euro is certainly within the mandate of the ECB!
- So, some form of containment of the so-called risk of fragmentation (a kind way to call the spread) is necessary, as well as inevitable. The containment will probably be achieved through differentiated purchases of debt securities of some countries only (those whose spreads rise too high), except if new instruments are invented.
- It is well known that the construction of the euro area is affected by the lack of the “second pillar”, i.e. the fiscal policy (which remained a national responsibility), alongside the monetary policy. A comprehensive reform of European economic governance is more than needed. A centralized fiscal capacity would be of crucial importance, at least in some sectors and to provide some public goods (health, transportation infrastructures, investments for the ecological transition, etc.). Therefore, a new common debt is advisable, on the example of what has been done with SURE and NextGenerationEU.
- Punctual and clear communication is a key instrument in modern economy, especially for central bankers. This is not astonishing that some sentences pronounced by Lagarde (announcement of anti-fragmentation tools and concurrent admission that there is still no operational plan) caused volatility on the markets. Lack of action and unclear statements may lead market operators to think that they can earn money by playing on country risk’s differentials.
Easy times, if ever existed, are over for central bankers.
Note
[1] Press conference of Christine Lagarde, President of the ECB, and Louis De Guindos, Vice-President of the ECB, Amsterdam, 9 June 2022.
[2] ECB’s Monetary policy decision, 9 June 2022.
[3] P. Pellegrini, Rising inflation and European monetary policy, Opinio Juris, 6 October 2021.
[4] EC, Spring 2022 Economic Forecast, 16 May 2022.
[5] Source: Eurostat.
Foto copertina: Christine Lagarde