The challenges facing the ECB

The European Central Bank is expected to move away from its easy-money policies at this week’s meeting. The central bank’s challenge is to do enough to reduce inflation without creating a recession.

| 6 min read

In May, Eurozone inflation hit 8.1%. Six countries in the bloc now have inflation of more than 10%, led by Estonia at 20%. The European Central Bank (ECB) will need to end its easy-money policies to deal with this significant price surge.

In Germany, which made a name for itself in the post-war era as a country with great financial discipline, inflation has hit an annual rate of 7.9%. This is a direct consequence of its membership in the single European currency, coupled with the loose-money policies of the ECB as it supports the struggling members of the EU through the pandemic recovery.

Germany has kept its own taxation, spending and borrowing strictly under control, but the ECB’s policy of creating billions of extra euros to buy-up government bonds from member states around the zone has taken the lid off price rises.

German inflation is not very different to the average in the Euro area. In its latest incarnation, it has been boosted, as elsewhere, by numerous factors including sky-high energy prices, the rising cost of food, consequences of the war in Ukraine, global supply-chain interruptions due to China’s “zero-Covid” policy, as well as by local shortages exacerbated by tight labour markets.

In recent history, any inflation rate of more than 2% would have horrified any German.

In recent history, any inflation rate of more than 2% would have horrified any German that understands the impact of the hyperinflation the country experienced in the Weimar Republic during the 1920s – a situation that ultimately ushered in a dark period of German history. Today, the worries of Germans have a much wider scope. Some are concerned about the trillion euro-plus that Germany has deposited at the ECB at a zero-interest rate. This has been lent on to the southern states with much weaker finances. Others are now agitated about how Germany should respond to Russian violence in Ukraine.

The old post-war settlement saw Germany, with modest self-defence forces, keep itself out of military action abroad, as well as becoming reliant on the US and NATO nuclear umbrella. It also kept its defence budget low, helping the public finances. Today, there are pressures to re-arm and to accept military responsibilities within Europe and NATO on a broader scale.

Chancellor Scholz stated that Germany will step up its arms budget substantially and send heavy weapons to Ukraine. However, since this statement, he has been criticised for backsliding. The defence-spending pledge appears to offer €100bn over a period of several years, diluting the impact of this large sum considerably. The weapons deliveries promised to Ukraine have also been delayed by bureaucratic issues.

Ukraine looms large over all EU policy

Against this background of German uncertainty, the European Council (EC) met at the end of May. It had four items on the agenda: Ukraine; oil-and-gas supply; food security; and European defence. In essence, the meeting was about just one issue. It was an extraordinary meeting to try to tackle the unresolved issue of how to combat Russian violence against a European neighbour that has a close Association Agreement with the EU. The meeting was needed because Ukraine has been critical about the lack of progress on imposing sanctions of significance that will really hit Russia, as well as the slow progress in delivering essential arms that have been previously promised.

It is true that the EU has imposed a range of sanctions on Russian trade and stopped various imports. The EC hoped to end Russian oil imports this year but eastern countries, led by Hungary, depend heavily on Russian oil delivered by pipeline. This means an early complete ban remains impossible.

The position with gas is even worse. Germany itself needs large quantities of Russian gas. There are good intentions to put in more liquified natural gas (LNG) capacity to be able to import more from elsewhere, but the underlying reality is that Russian gas flows will continue as the supply is vital to keep the country’s industry turning and German homes warm. It seems Ukraine will have to wait a little longer for a big reduction in euro payments to Russia.

The EU will come to play a bigger role in weapons procurement and in organising task forces and missions.

The EU aims to bring more of a European defence capability out of this. The EU will come to play a bigger role in weapons procurement and in organising task forces and missions for militaries based in EU member states. There will be some modest re-armament, with an immediate need to replenish stocks of ammunition, missiles and smart weaponry that has been given or sold to Ukraine. The EU also recognises the need to help world bodies keep Ukraine afloat financially with loans and other assistance.

It turned was a messy summit with little substantial agreement on how to change the pattern of fossil-fuel supplies and without much progress on food availability. Meanwhile, the ECB is still printing more euro, facing the twin problems of visible slowdown in growth at the same time as persistent inflation.

Its Financial Stability Report for May 2022 made grim reading. Whilst it points to better commercial-bank balance sheets that it believes can absorb any shocks, it warns of renewed bank-asset valuation and profitability concerns. It points out markets are vulnerable, anticipates wider bond spreads, rising interest rates, re-emerging credit risk, more pressure on vulnerable borrowers and a possible tightening of credit standards. The ECB officials are clearly preparing markets for a substantial tightening of monetary policy.

Christine Lagarde, as President of the ECB, may be more concerned about what tougher policy action will mean for economic growth – and to the electoral prospects of parties that challenge the EU line on policy. This week will be crucial for the control of inflation as the ECB announces its new policy. It is going to be difficult to do enough to control price rises whilst not doing too much so that it brings on recession. However, this is the dilemma faced by the ECB and other central banks around the world.

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The challenges facing the ECB

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