Monetary Policy
ECB faces tough choices as it prepares to raise rates
Robert Lind

So far in 2022, the European economy has held up remarkably well despite investor worries about a war-induced recession. But as the European Central Bank (ECB) prepares to hike interest rates at its July 21 meeting, the economy faces substantial challenges.

The ECB is dealing with a similar scenario to the U.S. Federal Reserve and the Bank of England, which are both struggling to rein in historically high levels of inflation without triggering a deep recession. The central bank has signaled its intention to increase interest rates at its July and September meetings and confirmed the end of its asset purchase program.

There’s also evidence that inflation expectations among consumers and companies have changed and started to drift upward. Given that real policy rates remain exceptionally low and inflation risks are increasing in Europe, the ECB will likely be eager to keep tightening until there is definitive evidence of a clear downtrend in consumer price index (CPI) inflation.

However, while robust consumption and services growth have powered the economy even as manufacturing has weakened to date, I see three major risks looming on the horizon that could make a soft landing difficult to achieve: a disruption to the continent’s gas supply from Russia; persistent, widespread inflation; and widening bond spreads (difference in yields) among European Union (EU) member states.

What can happen if Russian gas is cut off?

The threat of disruption to Europe’s energy supply from Russia has become very real over the past few weeks. Energy prices have already started to rise after a limited reduction in imports from Russia. And Berlin is clearly preparing for Russia to cut the gas off completely, which would then necessitate demand-rationing in Germany and other countries, like Italy.

If the flow of Russian energy is halted, it will add to inflation and put downward pressure on economic growth that could result in the biggest stagflationary shock since the mid-1970s.

Such a scenario would cause an acute dilemma for the ECB. If this were just about economic activity and an energy supply disruption creating a recession, it would suggest the ECB should be cutting interest rates. The problem is that if Russian gas is cut off, inflation will likely go even higher, possibly into double digits, which would indicate the ECB ought to keep tightening monetary policy.

It's worth bearing in mind that the one central bank that enhanced its reputation in the 1970s was the German Bundesbank, because it did not accommodate a supply shock inflation. It actually raised interest rates to squeeze out inflation. And I think German authorities will be under extreme pressure to do something similar this time. It might sound economically unwise to raise rates when an economy is experiencing recessionary pressures, but I think not doing so could create significant strains within the eurozone and within the ECB.

It is challenging to model the shock that would be caused by a halt to Russian energy imports, as the impact would feed through many channels: prices, volumes and uncertainty across all sectors of the economy. Moreover, macroeconomic models are estimated with historical data, which makes it hard to calibrate them for unprecedented scenarios. Nevertheless, estimates from Germany’s five economic research institutes and the ECB’s staff show that a complete cutoff of Russian energy imports would represent a huge and persistent negative supply shock to the European economy.

Potential impact of Russian energy cutoff

Chart shows the estimated impact on real (adjusted for inflation) GDP growth and HICP inflation in the euro area of a total shutoff of Russian energy (the downside scenario) as projected by the staff of the ECB. If Europe is cut off from Russian energy, real GDP could contract 1.5% in 2022 and 3.8% in 2023 before rebounding to 0.9% growth in 2024. The downside scenario could add 1.2 percentage points to inflation in 2022 and 2.9 percentage points in 2023 before cooling in 2024.

Sources: European Central Bank staff macroeconomic projections. Data as of June 2022. HICP = Harmonised Index of Consumer Prices. GDP = Gross domestic product.

Households and companies would likely have to bear a sustained loss in their real incomes. Further, government fiscal policy will likely not be able to completely offset these losses.

Risks of an inflation spiral are growing

The inflation spiral in Europe is not due solely to energy prices. The ECB publishes seasonally adjusted monthly indices for the main subcomponents of the eurozone’s CPI. Over the past three months, these indices have shown a broad-based pickup of inflation.

While energy prices are still contributing significantly to headline inflation, there have been notable increases in prices for non-energy industrial goods and services. In the three months to June, annualized core inflation, which excludes energy and food, grew from 3.9% to 4.6% compared with an increase from 2.4% to 3.2% in the three months to February.

Headline inflation rates remain elevated across the eurozone’s major economies. Germany’s 12-month headline inflation rate hit 8.2% in June and Italy’s rose to 8.5%. Among other EU’s major economies, France recorded the lowest inflation rate of 5.8% in May, although it rose to 6.5% in June, and Spain reported the highest rate of 10% in June (up from 8.5% in May).

Inflation reaches record highs in the EU

This chart shows inflation in Europe from 2002 through 2022 with a target rate of 2%. Headline inflation, which includes all items in the HICP, has grown rapidly since 2021, hitting 8.6% in June 2022. Core inflation, which excludes energy and food, has also grown significantly, although not as rapidly as headline inflation, touching 4.6% in June 2022.

Sources: Eurostat. Headline = All-items Harmonised Index of Consumer Prices (HICP). Core = Overall index excluding energy and unprocessed food. As of June 30, 2022.

The consensus among most ECB officials, notably Isabel Schnabel, the influential German member of the executive board, is that the scale of the inflation overshoot and extraordinarily loose monetary conditions require a rapid return to neutral policy rates. However, there is considerable uncertainty around where the neutral interest rate — one that neither boosts nor restrains the economy — lies. ECB staff members have suggested the neutral real interest rate could be around -1%, which would imply a neutral nominal rate of 1% to 2%. That said, estimates of neutral rates can change in tightening cycles.

The ECB is also concerned about underlying inflation dynamics. While wage increases have so far remained subdued, there is evidence that companies have been able and willing to raise their selling prices to protect profit margins in the face of substantially higher input costs. This has added to skepticism among many ECB officials about projections showing a quick drop in headline and core inflation. With tight labor markets and persistent inflationary pressures, wages could rise further. For instance, the German metalworkers union IG Metall has made an initial demand for an 8% wage increase later this year.

The United Kingdom is in an equally tight spot as it exits what Mervyn King, a former governor of the Bank of England (BOE), once called the “NICE” era of non-inflationary consistent expansion. Recent projections from the BOE show inflation rising to 11% later this year and then gradually returning toward the 2% target in late 2024 or early 2025. But this sits alongside a GDP projection that shows the economy growing anemically from the second half of 2022.

By the standards of other major economies, the U.K.’s current mix of high inflation and poor growth is notable. The country has experienced sustained weak productivity relative to other major economies and has run a current-account deficit for many years.

These structural weaknesses have amplified the effects of three massive supply shocks. The combination of Brexit, the pandemic, and the war in Ukraine are undermining the  U.K.’s underlying performance with some eerie echoes of the profound problems that beset the economy in the 1970s. In withdrawing from the EU’s single market, the  U.K. has increased the costs of trade for many  U.K. exporters and suffered a huge loss of trade flows with its largest market. Following Brexit, the  U.K. has also seen a sharp drop in its labor supply, aggravating the effects of the pandemic.

Italy’s weak economy makes ECB’s job tougher

The ECB’s pre-announcement of rate hikes and an accelerated end to its quantitative easing program, has already begun putting pressure on European bond markets, leading to wider spreads between yields on government bonds from EU nations.

The growing chasm between Italian and German government bond yields triggered an emergency meeting of the ECB in June, during which its governors talked about a new “anti-fragmentation” tool designed to address this spread widening.

Yet, there is no agreement within the ECB about what they should do and what that tool should look like. Staunch opposition from German and Dutch policymakers, who believe that the central bank should not subsidize the Italian government, is also complicating matters.

Anxiety in eurozone bond markets

This chart shows the differences in yield (spread) between German, Spanish and Italian 10-year government bonds from 2007 through 2022. Spreads began widening earlier this year after the ECB announced its plan to raise interest rates and wind down its bond-buying program.

Sources: FactSet. Data as of June 30, 2022.

Italy’s fundamental macroeconomic problems haven’t gone away. During the pandemic, it ran up substantial budget deficits and a significant increase in government debt. The economy has slowed recently in the face of the energy shock from the war in Ukraine. Disruption to Russian energy supplies could cause more problems for Italy.

If Italy’s situation worsens, it will force Berlin to decide when to deploy a backstop. I've always held the view that there is a backstop. But we don’t know how much pain will be needed before the EU steps in, and what conditions Germany might demand in return.

If the backstop does not materialize, the scale of the shock is now so big that it could conceivably start to erode the foundations of the euro. However, I am not someone who is naturally a euro-skeptic, and I don’t expect a full-blown Greek-style crisis, not least because I believe that policymakers have learned from their mistakes of the 2010s and they also recognize an Italian debt crisis would be far more dangerous for the eurozone. But still, a combination of diminishing ECB support and stiff political resistance to any fiscal measures to help Italy could add to the strain in bond markets, forcing spreads wider.

Bottom line

As the European Central Bank begins rolling back decades of ultra-loose monetary policy, it must strike a delicate balance on multiple fronts. Bringing runaway inflation under control should be the bank’s primary objective, but the threat of further disruption to the continent’s energy supply from Russia — as well as fragmentation among member-state borrowing costs — are likely to make it exceedingly difficult for the ECB to do so while avoiding a recession.

Robert Lind is an economist with 36 years of industry experience (as of 12/31/2023). He holds a bachelor's degree in philosophy, politics and economics from Oxford University.

The Harmonised Index of Consumer Prices (HICP) is used by the European Central Bank to measure inflation and price stability across the European Union.

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