Europe is in a paradox; I’m not even talking about the war in Ukraine. But the insinuation is interrelated. This crisis dovetails with the inflationary pressure exacerbated by the Russian invasion of Ukraine. The commodity prices are through the roof as sanctions are gradually taking effect on the commerce between the European Union (EU) and Russia. The current snapshot of the European economy defines the contours of inflation in the region. While quantitatively similar, inflation in Europe is nuanced compared to the US inflationary profile. The US prices spiraled due to the easy money injected by the US government to wade off an economic crunch during the pandemic. The inflation in Europe, on the contrary, is pivoted on energy and food shortages. Thus, while the US expects a brief period of economic depression, Europe is staring into the abyss of staple shortages, supply chain snarls, and a significant risk to organic economic growth.
Recently, the EU lowered its 2023 growth projection to 1.4% – a contraction from the expected growth of 2.6% in 2022. Yet as annual inflation in the EU jumped to 9.6% last month – a multi-decade peak – the European Central Bank (ECB) has no choice but to turn hawkish. While the shift away from easy money is in accord with the aggressive outlook adopted by the US Federal Reserve, the EU faces complexities that the Fed would never confront.
The ECB delivered a surprise last Thursday as it hiked the interest rates for the first time in over a decade. The ECB increased the benchmark rate by a larger-than-expected increment of 50 basis points. The move has effectively settled the deposit rate – which had been in the negative territory since 2014 – to zero. However, the unprecedented scale has pushed the refinancing operations rate to 0.5%; the marginal lending rate to 0.75%. According to the ECB statement released on Thursday, the “larger first step on its policy rate normalization path” was taken to “support the return of inflation to the Governing Council’s medium-term target” and ensure that “demand conditions adjust to deliver its inflation target [vis-á-vis 2%].” The policy shift appears in tandem with the aggressive approach adopted by almost every developed economy around the globe – except for Japan. However, the nature of the ECB’s monetary tightening differs with respect to intrinsic factors.
A rate increase of a half percentage point is (frankly) not as aggressive when compared with the tightening schedule implemented by other advanced economies. Since May, The Reserve Bank of Australia (RBA) has raised interest rates by 125 basis points – the fastest consecutive increments since 1994. The Bank of Canada hiked its benchmark interest rate by a percentage point last week – the single highest increase since 1998. And even the Bank of England (BOE) – once a constituent under the ECB – has increased its bank rate by 115 basis points – cumulatively in a series of rate hikes since December 2021. Evidently, the ECB is behind the curve – leading to the susceptibility of seepage of liquidity across the Atlantic. Yet, we need to realize one particular dimension, a distinctive quality that sets ECB apart from other central banks: it is responsible for setting the monetary policy for a chorus of developed (and developing) economies in Europe – not just a single advanced economy.
The ECB is the central bank of 19 European countries sharing the Euro as a fungible currency. A rate hike welcomed by stable economies like France could be detrimental to countries with unsustainable debt piles – like Greece, Italy, and Spain. Raising interest rates at the same pace as the US Fed – an implicit norm throughout the globe – could reignite the regional sovereign debt crisis as increasing borrowing costs would rapidly sink a few European nations into fiscal turmoil. Hence, the ECB has introduced a new tool, the Transmission Protection Instrument (TPI), to counter these “unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy.” Nonetheless, the risk of fiscal fragmentation remains viable as the implementation criteria is ambiguous. For instance, the ECB claims that its Outright Monetary Transactions (OMTs), governed under the TPI framework, would depend on the “severity of the risk facing fiscal transmission.” Thus, the ECB would be walking a fine line between fiscal consolidation and conducing fiscal irresponsibility. That line is particularly noticeable today. Following the ECB press conference on Thursday, yields on 10-year Italian bonds rallied; the Italian stock market trailed. All amid a political shuffle in Italy as Prime Minister Mario Draghi resigned for the second time in a week. Analyzing the volatile political atmosphere in Europe, I believe demarcating between the effects of sovereign fiscal incompetence and echoes of the ECB policies would be one of the most pressing challenges for the ECB in months to follow – perhaps second to the Russian threat to the European economy.
While the gas prices in Europe have shown some respite after a scare of blockade of the Nord Stream 1 (NS1) pipeline, the risk of retaliation still looms. The European Commission (EC) has directed a possible mandate for the EU nations to cut gas consumption (under their respective emergency plans) by 15% to prepare for a chilly winter without Russian gas. Nonetheless, countries like Hungary and Germany would almost certainly trip into a deep recession if Russia actually resorts to such a move. It increasingly seems likely! Gazprom – Russia’s state-controlled gas monopoly – retrospectively declared force majeure on deliveries from June 14th – capping potential gas supplies via the NS1 pipeline while safeguarding against litigation. Thus, further similar policy moves by the ECB – under the planned forward guidance – would be increasingly more difficult to enact as regional economies would increasingly suffer from stagflation – inching towards a steep recession.
Ultimately, the ECB announcement was not without a silver lining. The ECB has effectively managed to pump the Euro after it briefly fell to parity with the US dollar – for the first time in 20 years. But this is a temporary interlude as the future economic outlook of the EU spells gloom – from eroding consumer confidence to supply chain disruptions to high energy costs during bouts of sweltering climatic conditions. And therefore, I believe this confounding situation could culminate in only two scenarios: 1.) A miraculous end to the war in Ukraine, cessation of sanctions on Russia, and a subsequent end to the European energy crisis. Fantastical to even envision, I agree! 2.) A recession gripping more than half of the 19 nations of the EU – Germany leading the pack in mass economic deterioration.