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ECB Unity on Policy Path Is Fraying As Recession Danger Mounts

Hawkish ECB policy makers appear determined to extend the most drastic tightening in euro-zone history well into 2023.

ECB Unity on Policy Path Is Fraying as Recession Danger Mounts
ECB Unity on Policy Path Is Fraying as Recession Danger Mounts

The European Central Bank’s unity over the size of monetary-policy moves risks unraveling in coming months as officials diverge on the pain they reckon the economy can handle in the depths of the energy crisis.

With a window for public comments before the Oct. 27 decision about to close on Wednesday, the sum of multiple remarks in Washington in recent days by a spectrum of Governing-Council members point to underlying discord that is likely to become more pronounced as the year draws to a close. 

Just as the Federal Reserve remains fully focused on combating untamed US inflation pressures, hawkish ECB policy makers appear similarly determined to extend the most drastic tightening in euro-zone history well into 2023, complementing interest-rate increases with a prompt start to shrinking their €8.8 trillion-euro ($8.6 trillion) balance sheet. 

Meanwhile more dovish colleagues are getting nervous about the impact of such aggression after 125 basis points in hikes so far, pointing to cracks in the ECB’s resolve that may make the consensus President Christine Lagarde insists on increasingly hard to achieve. 

Such a crunch might well materialize once officials reach a level where borrowing costs are deemed to have a neutral effect on the economy, possibly around December. 

“We probably won’t stop raising rates there, but we will enter another part of the journey: a more flexible, and possibly slower one,” Bank of France Governor Francois Villeroy de Galhau said in a speech at Columbia University in New York last week. 

The sense of the end of 2022 as a turning point in the debate identified by the Frenchman, a self-proclaimed pragmatist refuting any specific label for his views, is a common theme. 

Hawks including Dutch Governor Klaas Knot and Latvia’s Martins Kazaks expressed similar views, while some colleagues seemed to voice preferences for more forceful moves to continue. 

“The ECB Governing Council must not let up too soon,” said Bundesbank President Joachim Nagel, while his Slovak colleague Peter Kazimir argued that “we need to keep powering through.” 

Belgium’s Pierre Wunsch, meantime, said it would be “reasonable” for the ECB to lift borrowing costs to 3% as even the mild recession he sees as the base case scenario in Europe will be insufficient to get inflation under control.

By contrast, their Italian colleague Ignazio Visco cautioned that 2023 will be “very difficult.” Portugal’s Mario Centeno warned that there could be a cost to maintaining such aggression at a time of huge economic uncertainty. 

European Central Bank Governing Council member Joachim Nagel says policy makers should be cautious about deploying tools to contain the borrowing costs of weaker nations. Such measures should only be used “exceptional circumstances and under narrowly defined conditions,” according to Nagel, the Bundesbank President. Alex Weber reports on Bloomberg Television.Source: Bloomberg
European Central Bank Governing Council member Joachim Nagel says policy makers should be cautious about deploying tools to contain the borrowing costs of weaker nations. Such measures should only be used “exceptional circumstances and under narrowly defined conditions,” according to Nagel, the Bundesbank President. Alex Weber reports on Bloomberg Television.Source: Bloomberg

“The worst case for all of us is if we at some point need to go back and forth,” he said. “We need to be a source of stability. We can’t be seen as going nowhere or at some point having to backtrack on our decisions.”

Officials in Washington were confronted with a drastically worsened outlook, with the IMF slashing its 2023 forecast for euro-zone growth by more than half to just 0.5%. Germany and Italy will see outright contractions during the year, the projections show.  

Lagarde publicly insisted that -- despite an economic consensus to the contrary -- the euro zone isn’t currently in recession. But her vice president, Luis de Guindos, acknowledged that such an outcome on a “technical basis” is possible. 

In addition to the challenges of calibrating rates in gloomy and uncertain times, the ECB will also face the question of what to do about the extremely generous terms of more than €2 trillion of long-term loans. Some officials reckon it’s legally feasible to retroactively change their generous rules for banks.

ECB Unity on Policy Path Is Fraying As Recession Danger Mounts

Another issue is what to do with €3.3 trillion of assets bought up by ECB to buoy dormant inflation that’s now at 10% -- five times the target -- without prospects of falling back to 2% until 2025 at the earliest.

Ideas for when the ECB should start rolling off bonds from its balance sheet, a process known as quantitative tightening, range from Wunsch’s “as soon as possible” to Nagel’s preference for “a timely manner” to Finnish Governor Olli Rehn’s idea of sometime “in the first half of next year.”

With this debate in its early days, policy makers favor caution. Any efforts to shrink their bond portfolio will run in the background and likely start slowly to test how much financial markets can digest. Knot evoked former Fed Chair Janet Yellen’s likening of QT to watching paint dry.

ECB Unity on Policy Path Is Fraying As Recession Danger Mounts

As for more immediate decisions, Lithuania’s Gediminas Simkus, Austria’s Robert Holzmann and Slovenia’s Bostjan Vasle were among those signaling rate increases of 75 basis points in October and 50 to 75 points in December. 

ECB Chief Economist Philip Lane was more reticent about what policy course he’ll propose to colleagues in less than two weeks.

“It’s clear we’ve moved away from a situation where the maximum increment is 25,” he said, but “we still have to work on our optimum speed.”

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