As Mark Twain supposedly opined, “History doesn’t repeat itself, but it often rhymes.” Right now, the European Central Bank right may not only be experiencing a sense of deja vu — but fear of a big, bad thud resounding all over again.
The ECB’s Governing Council faces a momentous decision on Thursday: How aggressive should it be combating repeated surges in inflation? The tricky bit is not to tip the euro zone into recession and render pointless the trillions in pandemic support poured out since 2020.
The last time the central bank embarked on rate hikes — under then-President Jean-Claude Trichet and on the eve of a recession — it precipitated the 2011 euro crisis from which the continent has never fully recovered. This is a mighty brave time to be tightening financial conditions again: The Russians have shuttered the Nord Stream pipeline for the foreseeable future, a frosty omen for the continent’s industries. The other signs aren’t good: This week’s ECB meeting is also a quarterly economic review that will likely see inflation forecasts for 2022 revised sharply higher again — from 7.5% to above 9%. Growth forecasts look set to be trimmed lower.
The presidency of Christine Lagarde looks increasingly rudderless as the hawks on the Governing Council take back control following eight years of negative rates. A clearly divided council isn’t going to calm markets. Lagarde was appointed for her political acumen rather than her economic chops, but if the ECB decides on a 75 basis-point hike — instead of repeating a half percentage point — it would suggest she’s no longer really in control.
Euro money-market futures don’t believe dovishness will prevail. They’ve almost fully priced in what would be the largest hike in the euro’s operational history: from zero to 0.75%, as well as further hikes up to 2% by early next year. This may seem unrealistic with faltering economic growth, but traders need to hedge for unexpected rate exposure.
Lagarde didn’t attend the Federal Reserve symposium at Jackson Hole, Wyoming, contributing to a six-week vacuum of specific monetary remarks from her. She did provide some hint, in a Madame Figaro interview on Aug. 25, that, “We can no longer rely exclusively on the projections provided by our models — they have repeatedly had to be revised upwards over these past two years.” That’s hardly a clear expression of strategy.
Instead, much of the signaling has come from her executive board colleague Isabel Schnabel of Germany, who has emphasized the de-anchoring of inflation expectations. That has overshadowed chief economist Philip Lane’s plaintive pleas for a multi-step calibrated series of hikes and fueled speculation that higher and faster interest rates are coming. The ECB’s July consumer inflation expectations survey released on Friday showed that price gains are still expected to run at a 3% pace in three-years time. With core inflation climbing to 4.3%, the pressure to do something on inflation is no longer just about runaway energy prices.
The ECB has a lot to tackle this week but doing everything at once is going to tighten financial conditions savagely. It has to decide when to reduce its 9 trillion euro balance sheet. The likelihood is later this year. It will also have to curtail 2.2 trillion euros of incredibly generous bank funding, at rates as low as minus 1%, under the Targeted Longer-Term Refinancing Operations. Schnabel recently suggest that discussions would start soon on shrinking the central bank’s 5 trillion-euro QE holdings.
Italy’s 10-year yield spread over German bunds is also within a hair’s breadth of where the ECB called an emergency meeting in June. At that time, it came up with a control-the-spreads Transmission Protection Instrument; it should provide further details of how it will actually work.
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Meanwhile, other signals from Bundesbank President Joachim Nagel have been distinctly frosty. It’s significant that the hawkish minority is led by both German representatives on the Governing Council. This means it has teeth.
But Schnabel, Nagel and the other hawks are playing with significant risks. If recession becomes inevitable, higher rates will be painful so soon after the sharp economic downturn that resulted from the pandemic.
A larger-than-expected 50 basis-point hike in July — as well as the hastily-arranged outlines of the anti-fragmentation instrument — failed to control spread-widening within the bloc or prevent the euro from falling below parity to the dollar. The ECB is getting no respite from the Fed’s unswerving determination to raise interest rates further and faster than other major central banks. Fed Chair Jerome Powell took a distinctly hawkish line at Jackson Hole, with expectations now leaning to another 75 basis-point hike on Sept. 21. It’s hard to compete against that.
The brutal reality is the euro-zone economy has none of the luxuries afforded by the US’s economic strength, energy independence or global reserve currency. Its choices now are fraught with danger. Overly aggressive hikes risk echoing Trichet’s 2011 mistake. Let’s hope history neither repeats nor rhymes.
More From Other Writers at Bloomberg Opinion:
• The Euro’s Drop Below $1 Means a More Hawkish ECB: Marcus Ashworth
• A Surging Dollar Is a Mixed Blessing for the US: Mohamed A. El-Erian
• What the Hawks Didn’t Get at Jackson Hole: Daniel Moss
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
More stories like this are available on bloomberg.com/opinion
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