The ECB estimates that the de facto tax from higher energy costs reduced consumer incomes and business earnings by 150 billion euros ($163.7 billion) in the last quarter of 2021 compared with a year earlier. The final tally will only rise the longer the war in Ukraine disrupts the commodities markets, raising the risk of a recession in the next year.
The result is a record high 7.5% rate of inflation in the eurozone, well above the ECB’s 2% target. Inflation rates are high globally, reflecting supply chains bottlenecks and underinvestment in key industries, but eurozone demand conditions differ.
For example, its labour market didn’t see the workers leaving jobs during the lockdowns and not returning to the degree seen in the US, or the skills drain that the UK saw due to Brexit. As a result, wage growth has so far largely held within the ECB’s comfort zone.
The truth is that the ECB has no good options to temper inflation. With energy prices up 40% from a year ago and far outstripping growth in eurozone demand, the only way to return inflation to target outside the region finding a new source of cheap energy outside Russia is via demand destruction.
That means lifting interest rates sharply higher even though disruptions in supplies force businesses to cut production and erode consumers’ spending power. Not only won’t rate hikes shield businesses and consumers from surging energy costs, but higher borrowing costs will make it more expensive for governments to avoid a recession, especially for the continent’s largest debtors such as Italy and Spain.
What’s more, the unwinding of ECB asset purchases may cause sovereign bond yields from highly indebted countries in the south to rise more than those from the fiscally conservative north, further raising business capital costs and slowing growth for a large portion of the continent even before policy rates have increased.
For an economy that has relied on ECB buying of government bonds to keep market frictions at bay after the region’s sovereign debt crisis, the end of quantitative easing will mean a painful adjustment.
This is especially the case for Italy, the continent’s largest borrower, whose 2.7 trillion euros of debt, which equates to 150% of GDP, carried an average cost of 6% before the ECB launched its Pandemic Emergency Purchase Programme in 2020, well above expected future nominal GDP growth.
Rather than sticking to a predetermined path in normalising monetary policy, the best course of action for the ECB will be to maintain flexibility to respond to an evolving trade-off between growth and inflation risks amid more volatile markets. In other words, the ECB will have to learn and act as conditions change.
This demands a gradual approach to how the central bank prepares to exit its pandemic-era toolkit of large asset purchases and negative interest rates. Policymakers need to be nimble in how they adjust policy rate guidance in response to faster inflation, distinguishing between demand-led, wage-driven inflation and an external supply shock to real incomes and growth.
Flexibility is also going to be critical in terms of how the central bank ends quantitative easing. It may require the ECB to step into government bond markets via direct interventions to prevent excessive volatility in borrowing costs and protect lenders’ funding conditions even as liquidity is withdrawn.
In times of war and extraordinary uncertainty surrounding growth and inflation, perhaps the greatest power that monetary policy can exercise is to ensure liquid, calm and well-functioning public and private investment markets.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.
More stories like this are available on bloomberg.com/opinion
How the ECB should begin to normalise monetary policy
Image: Bloomberg
The war in Ukraine has left Europe facing both greater supply chain disruptions and higher prices for raw material, problems worsened by the region’s dependency on Russia energy.
Against this backdrop, the European Central Bank must find a way to guard against an extended inflation shock and economic slowdown, all the while rolling back support for financial markets in the midst of heightened turbulence in global bond and commodity markets.
Rather than a predetermined path of policy “normalisation,” ECB President Christine Lagarde and her fellow policymakers need a new playbook to navigate the volatile period for growth, inflation and markets that lies ahead.
The pandemic exposed the complex and fragile nature of supply chains. Now, mounting sanctions on Russia means the continent faces no choice but to source new trade suppliers and restructure delivery routes across key industries, from energy to metals and fertilisers, while shoring up the immediate shock of business disruptions and plummeting consumer confidence due to soaring food, gas and consumer goods prices. These are issues well beyond what governments or the central bank can control.
What’s more, the eurozone faces a structural demand shock. A step up to higher costs for raw materials — not just gas but also agricultural commodities and “green energy” metals, for which Russia is also a key supplier — means a permanent decrease in what businesses and households can spend on other things, depressing investment and future job creation.
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The ECB estimates that the de facto tax from higher energy costs reduced consumer incomes and business earnings by 150 billion euros ($163.7 billion) in the last quarter of 2021 compared with a year earlier. The final tally will only rise the longer the war in Ukraine disrupts the commodities markets, raising the risk of a recession in the next year.
The result is a record high 7.5% rate of inflation in the eurozone, well above the ECB’s 2% target. Inflation rates are high globally, reflecting supply chains bottlenecks and underinvestment in key industries, but eurozone demand conditions differ.
For example, its labour market didn’t see the workers leaving jobs during the lockdowns and not returning to the degree seen in the US, or the skills drain that the UK saw due to Brexit. As a result, wage growth has so far largely held within the ECB’s comfort zone.
The truth is that the ECB has no good options to temper inflation. With energy prices up 40% from a year ago and far outstripping growth in eurozone demand, the only way to return inflation to target outside the region finding a new source of cheap energy outside Russia is via demand destruction.
That means lifting interest rates sharply higher even though disruptions in supplies force businesses to cut production and erode consumers’ spending power. Not only won’t rate hikes shield businesses and consumers from surging energy costs, but higher borrowing costs will make it more expensive for governments to avoid a recession, especially for the continent’s largest debtors such as Italy and Spain.
What’s more, the unwinding of ECB asset purchases may cause sovereign bond yields from highly indebted countries in the south to rise more than those from the fiscally conservative north, further raising business capital costs and slowing growth for a large portion of the continent even before policy rates have increased.
For an economy that has relied on ECB buying of government bonds to keep market frictions at bay after the region’s sovereign debt crisis, the end of quantitative easing will mean a painful adjustment.
This is especially the case for Italy, the continent’s largest borrower, whose 2.7 trillion euros of debt, which equates to 150% of GDP, carried an average cost of 6% before the ECB launched its Pandemic Emergency Purchase Programme in 2020, well above expected future nominal GDP growth.
Rather than sticking to a predetermined path in normalising monetary policy, the best course of action for the ECB will be to maintain flexibility to respond to an evolving trade-off between growth and inflation risks amid more volatile markets. In other words, the ECB will have to learn and act as conditions change.
This demands a gradual approach to how the central bank prepares to exit its pandemic-era toolkit of large asset purchases and negative interest rates. Policymakers need to be nimble in how they adjust policy rate guidance in response to faster inflation, distinguishing between demand-led, wage-driven inflation and an external supply shock to real incomes and growth.
Flexibility is also going to be critical in terms of how the central bank ends quantitative easing. It may require the ECB to step into government bond markets via direct interventions to prevent excessive volatility in borrowing costs and protect lenders’ funding conditions even as liquidity is withdrawn.
In times of war and extraordinary uncertainty surrounding growth and inflation, perhaps the greatest power that monetary policy can exercise is to ensure liquid, calm and well-functioning public and private investment markets.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.
More stories like this are available on bloomberg.com/opinion
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