Should ECB normalise its monetary policy?

The central bank needs some new tools to navigate the unique challenges that are likely to confront the euro-zone economy. The war in Ukraine has left Europe facing both greater supply chain disruptions and higher prices for raw material, problems exacerbated by the region’s dependency on Russia energy. Against this backdrop, the European Central Bank (ECB) 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 policy makers 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 euro zone 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. The ECB estimates that the de-facto tax from higher energy costs reduced consumer incomes and business earnings by $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 euro zone, well above the ECB’s 2% target. Inflation rates are high globally, reflecting supply chains bottlenecks and underinvestment in key industries, but euro zone 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 euro zone demand, the only way to return inflation to target outside of the region finding a new source of cheap energy outside of 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 following 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 gross domestic product, carried an average cost of 6% before the ECB launched its Pandemic Emergency Purchase Programme in 2020.

—Bloomberg