EKT and the ‘ghosts’ of 2012

In Europe we are experiencing a new déjà vu. It was almost a year ago that Christine Lagarde promised that the European Central Bank had learned from the mistakes of previous crises and would not derail the economic recovery by withdrawing emergency support too early.

The ECB president’s comments were a reference to the fateful cycle of interest rate hikes in 2011, which began with an increase in April and continued with another in July. These moves were deemed premature and were reversed later that year, when Mario Draghi took over as ECB president, at a time when the eurozone debt crisis was entering a more dangerous phase.

That turmoil, which started in Greece and soon spread to other economically vulnerable members of the Eurozone, threatened to break up the euro, until Draghi famously said “whatever it takes” to protect the single currency – and soon after revealed a new tool to support his claim.

At the time, the ECB was criticized for raising interest rates in order to combat a escalating price rise that soon petered out. This time, the central bank, led by Lagarde, is being criticized for lagging behind, allowing inflation to rise to the highest level since the creation of the euro in 1999.

On July 21, policymakers kicked off a new cycle of rate hikes that they predict will last until 2023, moving to a 0.5% increase. In what looks like a repeat of 2012, they will have to face a new period of market speculation, focused on a weaker member of the eurozone – this time Italy.

Hesitations

The ECB stands out as one of the last major central banks to raise interest rates. With inflation now at 8.6% and on an upward trend, with forecasts constantly being exceeded, the risk of prices spiraling out of control is making its officials more active.

Forecasts released in early July by the European Commission showed that even next year, price growth will average 4% – twice the ECB’s target.

With the war in Ukraine already fueling inflation through higher energy, fertilizer and food prices, officials are weighing the impact the euro’s fall to 1:1 against the dollar could have on import costs, as well as the possibility that Russia to cut off natural gas supplies.

All but 6 of 28 analysts in a recent Bloomberg survey said the ECB has fallen behind on tightening monetary policy. Moreover, the ECB is not yet considering a rate hike as big as the Federal Reserve’s (by 0.75% each) in June and July.

Officials are hesitant to take an overly aggressive approach amid mounting signs that a recession is looming in the Eurozone, even without cutting off Russian gas flows. There is a 45% chance of a recession in the next 12 months, according to a Bloomberg survey – up from 30% just a month ago. The possibility is even greater in Germany, Europe’s largest economy, which relies more than others on Russia for natural gas.

Tool

Another argument for the ECB not to rush is the possibility that any big move in interest rates could exacerbate the turmoil centered on Italy, where Mario Draghi has resigned as prime minister – his next big post after leaving the ECB at the end of 2019 .

Unlike Greece, a much smaller country whose exit from the euro would not threaten its overall integrity, the exit of the eurozone’s third-largest economy would pose a structural risk. Italy was a founding member of the European Coal and Steel Community, a precursor to the European Union, so it is hard to imagine a common European currency without it.

In June, when Lagarde formally confirmed a timetable for rate hikes, investors immediately focused on the prospect that Italy’s higher public debt servicing costs, estimated at 150% of its GDP, could become potentially unsustainable. The yield on Italy’s 10-year bond climbed above 4% for the first time since 2014 amid a sell-off. The ECB president was forced to call an emergency meeting to rally officials around the idea of ​​creating a new tool to deter profiteering.

Policymakers’ ambition is to emulate the success of the instrument presented by Draghi a decade ago. Called Outright Monetary Transactions (OMT), it allowed the ECB to buy government bonds of weaker euro members to hold down yields, in exchange for their governments meeting strict economic policy conditions. Its mere existence helped keep speculators at bay without requiring its use. However, the political “stigma” it carries has since fallen out of favor.

Lagarde is thus left with the task of emulating Draghi by creating a new valve to awe investors. Whether the Transmission Protection Instrument (TPI) can succeed is a question that will be answered in the coming weeks, months and years.