It will be a bad period for the European Central Bank

The European Central Bank’s decision to raise interest rates last week following deteriorating inflation data, i.e. price hikes, is considered the most significant change in monetary policy in Europe over the past decade. The ECB decision is also, probably, one of the most difficult in the institution’s recent history, which could jeopardize not only its credibility but also the economic resilience of the EU.

While action is needed to control inflation, depending on how the ECB moves, the consequences could be very dire.

Too decisive action on rates could trigger a recession in the eurozone, while too timid measures may not be enough to control inflation: the right balance is too complex, and much will depend on interpretations of the direction of the already highly challenged economy. For now, the mere announcement of a rate hike is causing major problems for weaker and more indebted European economies, such as those of Italy and Spain: the European Central Bank on Wednesday announced extraordinary measures to protect these countries from rising spreads and a new debt crisis.

The European Central Bank was the last of the major Western central banks to decide on a rate hike, months after the US Federal Reserve and the Bank of England, among others, began changing their monetary policies to contain inflation. The reasons for this delay are numerous, but one of the main reasons is that compared to other banks, the European Central Bank has more concerns, mainly related to the economic weakness of more indebted countries, such as Italy.

Last week, the announcement that early July would raise interest rates and end the European Central Bank’s bond-buying policies was enough to raise the spread between Italian and German government bonds immediately, reaching levels not seen since 2014.

The spread is one of the main indicators of a country’s economic reliability and determines how different the yield is between Italian and German government bonds. Germany is considered the most economically reliable country in Europe: that is why the yield on its government bonds is very low and is used as a benchmark for comparison with the yield on government bonds of other countries. The greater the difference, the more risky this country is compared to Germany – and that difference is the difference.

In recent days, the Italian spread has risen significantly as markets fear that the Italian economy (like those of Spain and Greece) will be more difficult to pay off its debts due to higher rates and a possible recession down the road. to act accordingly. “All this interest in Italy began to be remembered in 2011,” he said. financial times A financial analyst, pointing to the year when Europe’s sovereign debt crisis reached its peak.

In this Sole 24 Ore chart, we can see the spread increase quite clearly after the price hike was announced on June 9.

For this reason, the European Central Bank held an emergency meeting on Wednesday, just a week after the last meeting of its members (the meeting in Amsterdam where it was decided to raise the interest rate). These emergency meetings are rare, the last of which was in 2020 to talk about the huge crisis caused by the epidemic, and this gives an idea of ​​the gravity of the situation. After the meeting, European Central Bank President Christine Lagarde announced that the central bank would develop new measures to limit the spread of weaker countries and avoid the outbreak of a new debt crisis: Bloomberg He described these measures as explicitly required “to avoid a new Italian crisis.” It is not yet clear what it will consist of, but it will almost certainly be new government bond purchase programs.

The announcement calmed the markets, at least for the time being, and the spread narrowed.

But these first notable difficulties encountered by the European Central Bank show that for the central bank, the significant change in monetary policy that was necessary due to the increase in inflation would be very complicated.

The interest rates we are talking about are the ones at which central banks lend money to other banks, which is basically the cost of money. Historically, raising interest rates is the best weapon available to central banks to control inflation, because increasing the cost of money reduces the phenomena that causes prices to rise. Simplifying too much, as interest rates rise, the investment becomes less convenient, and the economic risk becomes more risky: applying for a mortgage to buy a house, a loan to buy a car, or a loan to open a new business becomes more expensive. The result is that consumers and business often postpone investments, causing the economy to “cool down” and thus lower inflation: they buy less, invest less, do less business, and prices fall.

However, the side effect of a higher price is that if the economy calms down too much, there is a risk of a recession, which can then become difficult to get out of. This is why central banks have a particularly delicate task: they must “cool” the economy just enough to control inflation, but not too much. This balance is also difficult to achieve, because the effects of rising interest rates usually appear after months, and there are no reliable indicators to predict how things will turn out: it must be based above all on experience.

All central bankers who have changed interest rates in recent months are well aware of this problem. In the United States, the debate over whether it is appropriate to raise interest rates and jeopardize economic growth has been going on for months, and it seems that the Federal Reserve only recently decided to listen to those who think drastic action is necessary: ​​its chair, Jay Powell, announced the largest rate increase on Wednesday. Since 1994.

But for the European Central Bank, things are more complicated, because recently its role and activity has changed. Although, according to the statute, the primary task of all central banks is to keep prices under control, as then-President Mario Draghi declared “whatever it takes” (in 2012, in the midst of the crisis in Europe), the bank’s mission has changed The ECB is largely, albeit unofficially: in the past ten years the central bank’s resources and attention have focused almost exclusively on maintaining unity in the eurozone, through expansionary policies such as stock buying, which have mainly supported weaker countries such as Italy and Spain.

That’s why the European Central Bank has been among the last to act against inflation, and that’s why so far there is still some uncertainty – and a lot of controversy – about what its next steps should be.

The European Central Bank headquarters in Frankfurt (Thomas Lohnes / Getty Images)

Within the European Central Bank (whose monetary policy is decided by a 25-member governing body), as well as among European governments, debate over the nature of high inflation and how to deal with it has been going on for months.

The prevailing interpretation now (especially after the very worrying data of the past few weeks) is that inflation has already returned to a systemic level and that an aggressive and swift policy is needed to bring it under control. This explanation is supported by the so-called “hawks”, advocates primarily from northern European countries, who desire very significant price increases and that the European Central Bank is completely abandoning the growth stimulus policies adopted in the last decade.

“Inflation rates in the eurozone will not go down on their own,” Bundesbank President Joachim Nagel said recently, adding that “resolute measures” were needed.

Hawks argue that tight monetary policy is necessary even at the cost of suffering a short-term recession, to avoid worse long-term damage. on me financial times Economic journalist Chris Giles reported that in the 1970s, the last time Europe had to deal with high inflation, the Bundesbank raised interest rates sharply, and the country endured the pain and suffered a short, shallow crisis. Conversely, countries that chose “a more favorable path, such as Italy and France” had to struggle with inflation for longer, and ultimately found themselves in a much deeper recession.

The opposite interpretation is the so-called “doves”, to which many advocates of southern European countries belong, who argue that the inflation that has been affecting Europe in recent months is due to economic factors such as an increase in the cost of energy, which in turn leads to an increase in the cost of all other activities. According to this hypothesis, it makes no sense to raise interest rates and “cool down” the entire eurozone economy, even to risk a recession, if the reasons for the increase in inflation lie elsewhere.

For example, economist Francesco Giavazzi, an economic advisor to Prime Minister Draghi and a confidant of him, said that the rate increase in response to rising inflation was a “wrong tool”. We do not have demand inflation as in the United States, but we have inflation linked to the price of gas.” According to Giavazzi, raising interest rates may not be effective enough against inflation, but rather lead to a decline in “private demand”, with the consequent slowdown in the economy, and possibly a recession.

The very difficult task of the ECB will be to extricate itself in the midst of these opposing pressures, realizing that whatever it is doing is likely to risk significant criticism, and that the best possibility would be to reduce the damage, not eliminate it entirely. To make this task more complicated is the fact that, like financial timesOf the 25 board members, only one, Dutchman Klaas Knott, was part of the group the last time the central bank raised interest rates, in 2011, and has first-hand experience of how things are and how things might work.

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