ECB has more at play and risk than the Fed

Thursday was expected to bring the spotlight to Europe, and what could be a historically consequential meeting on monetary policy by the European Central Bank (ECB). It’s going to raise rates. But there is now some question over how much — 25 or 50 basis points? And the constraints have never looked tighter.
We all know that the world as a whole suffered from a pandemic, and is now suffering inflation in its aftermath. But the ECB has to deal with three pressures that don’t affect the Federal Reserve.
It appears that the resignation of Mario Draghi as Italy’s prime minister is at last a done deal. That amps up uncertainty, which in turn tends to amplify the spread between the yields on Italian and German bonds. This is a key measure of political risk, or specifically of the risk that the eurozone begins to fragment.
The more aggressively the ECB chooses to hike, the greater the concerns over the Italian economy, so Italian yields rise by even more, taking the spread even higher. Italian political drama on the eve of a rate decision is thus as unwelcome a development as bank President Christine Lagarde and her colleagues could possibly imagine.
Whatever the ECB chooses to do, it’s going to have to produce good and convincing details on how it can stop this spread widening further. If there was any doubt over this, Italy’s latest political crisis has removed it.
Unlike the Fed, whose decisions on credit are generally refracted through markets, the ECB must contend primarily with the banking system. That’s a problem because Europe’s banks have been far weaker than those of the US ever since the Global Financial Crisis. And the latest edition of the ECB’s quarterly survey of senior lending officers at eurozone banks show that both the supply and the demand for credit are falling rapidly.
Most awkwardly for the ECB, the health of the banks tends to accentuate the fragmentation risks within the eurozone.
The ECB wants to start withdrawing its support for the banking system through the “TLTRO” (targeted longer-term refinancing operations) loans, with which it has been easing pressure on banks. The terms are generous and this makes sense — but again, Barclays warns that it could have greater impact in peripheral economies. In short, the banking system could multiply any monetary tightening to take it to a dangerous level.
Europe is not just waiting for the ECB to announce new interest rates; Thursday was expected to also give some formal indication of how much energy Russia is prepared to provide, as maintenance work on the crucial Baltic Nord Stream pipeline is due to be completed.
The stakes are high. According to the International Monetary Fund, cutting off Russian energy could on its own cause the German economy to shrink by almost 5%. In a genuine cliffhanger, we must await dawn in central Europe — roughly when this newsletter should be reaching you — to see how much gas is actually getting through. The head of Germany’s grid said that Russia had arranged for the pipeline to work at 30% capacity. Within a few hours of the pipeline moment of truth, the ECB will need to say what it’s doing about monetary policy.

—Bloomberg