Capital Economics: Why raising ECB interest rates now is not a repeat of the 2011 mistake

Her Eleftherias Kourtali

The ECB’s rate hike in 2011 was wrong, not least because it led to an even greater expansion of the region’s bond spreads, according to Capital Economics. Inflation was subdued, and policymakers were very concerned about acting proactively to contain inflation expectations. Therefore they could hardly be blamed for their reaction this time, as he notes.

Given the outlook for inflation, the view for monetary policy normalization is now much stronger. As the ECB prepares to start raising interest rates in July, Capital Economics points out that it’s worth taking a look at the last time it did so, in April and July 2011, and making some comparisons with today.

These increases were a mistake, the house says, apparently because the debt crisis was already under way. The spreads have been widening for months and, with the exception of Italy, have been much wider than they are today. The spread of 10-year bonds to Bunds was over 9% in Greece, almost 6% in Ireland and over 5% in Portugal.

But to be fair to policymakers at the time, he notes, this mistake was not as obvious as it seems afterwards. In the day before interest rates rose in April 2011, investors saw a gradual tightening of monetary policy in the following years.

President Trichet then explained that the ECB was acting because of the positive “momentum of economic activity” and the “upward risks to price stability”. GDP growth was above trend throughout 2010, and at the beginning of 2011 the composite PMI showed continued strong growth. Inflation, meanwhile, was above target and Trichet highlighted four upside risks: stronger-than-expected domestic price pressures, higher energy prices, increases in indirect taxes and prices as governments reduced their budget deficits. and rising inflation expectations.

However, there was reason to be skeptical of the ECB’s justification for raising interest rates. There was still a large overcapacity in the economy. At the end of 2010, the eurozone GDP was more than 2% below pre-crisis levels and the unemployment rate had just fallen from its 2010 highs. to a large extent in energy prices, especially gas. The key interest rate was still below 2%.

In addition, the upside risks to inflation were likely to be lower than policymakers thought, according to Capital Economics. Business surveys showed that labor shortages were still well below pre-financial levels and that there were few signs of a significant acceleration in wage growth. Meanwhile, a higher level of energy prices, or increases in indirect taxes and prices, were unlikely to lead to a steady rise in inflation unless they raised inflation expectations. And inflation expectations were not out of control at all. For example, while consumer expectations were rising, they were still below the pre-crisis average.

Overall, Capital Economics points out, policymakers were very willing to take precautionary measures before inflation and inflation expectations went out of control. The contrast with today could not be more intense.

Admittedly, in the first quarter of this year, GDP was just 0.4% above the level of the fourth quarter of 2019 and household consumption was probably around 3% below this level. (In contrast, US consumption was 5% above pre-Covid levels.)

However, inflation is now much higher than it was in 2011 and there are signs that it will be more persistent. Inflation expectations are rising from already high levels, surveys show that labor shortages are at record highs and wage growth is accelerating.

Therefore, as Capital Economics concludes, the extremely relaxed political stance of the ECB in recent years no longer seems justified. With all this in mind, he believes the ECB will raise the deposit rate from -0.5% to + 1.5% by the end of next year, which is a higher level than what is priced in the markets. However, he warns, this degree of tightening risks exacerbating problems in regional bond markets.

After all, in its view the prospect of tighter monetary policy in the eurozone threatens with a larger sell-off in the bond markets of the region. If that happens, he believes the ECB will eventually intervene to prevent any permanent damage, but he doubts he will agree to the details of a new QE program until it is urgently needed, so he believes the eurozone bond market is vulnerable to a sharp sell-off. This in turn could make life more difficult for governments and companies in the periphery.