Is zero a destination for ECB’s interest rates?

Who would be a central banker in these febrile times, trying to navigate a path between soaring prices and a gloomy growth outlook? While policy makers everywhere face similar challenges, the ECB task is particularly tricky given its deeply negative interest rates. With the money market pricing in a rapid climb in borrowing costs that would threaten to tip the bloc into recession, a monetary compromise is needed.
Europe is far more exposed to the energy risks stemming from Russia’s invasion of Ukraine. Moreover, the geographical proximity of the war is causing a humanitarian crisis and raises the prospect of real economic hardship in the region.
Germany’s annual inflation rate soared to 7.6%, with figures outstripping economists’ forecasts for a rise to 6.8%. Spanish consumer prices were also a shocker, climbing by 9.8% versus the 8% consensus estimate. The euro-zone number looks set to surpass the 6.7% rate anticipated by economists. And the ECB’s forecast for inflation to average 5.1% this year, made just a few weeks ago, already looks hopelessly optimistic, with economists at UniCredit predicting 6.45% and Danske Bank seeing 7%.
Meantime, the growth outlook is deteriorating rapidly. Germany’s Council of Economic Experts slashed its 2022 forecast for expansion in Europe’s biggest economy to 1.8% from 4.6% previously. Economists were already predicting a slower expansion for the euro region than the ECB’s latest projection.
Moreover, the German government advisers warned of a “considerable risk” of growth slowing enough to make a recession possible because of the country’s dependence on Russian oil. Economists surveyed by Bloomberg put the likelihood of two consecutive quarters of output contracting in the euro zone at 30%, the highest since Covid lockdowns prompted similar concerns a year ago. But with the Federal Reserve and the Bank of England both raising interest rates, the ECB is in danger of looking out of step if it doesn’t do something to show it’s paying attention to its price stability mandate. Its deposit rate is currently -0.5%; the swaps market is pricing in more than half a point of increases by the end of the year.
A “significant minority” of the Governing Council is clearly agitating for an end to quantitative easing this summer, paving the way for borrowing costs to move higher. ECB Chief Economist Philip Lane laid out the daunting task ahead in an interview with Politico. He cited a drop in economic sentiment as a “major concern” for policy makers, stressing that inflation is expected to ease back below target next year and highlighting that the central bank is seeking “flexibility and optionality” in its monetary framework.

—Bloomberg