Lagarde’s Inflation-Fight at ECB Makes Fed’s Job Look Simple

(Bloomberg) --

Just a quarter-point of interest-rate hikes is all that separates the European Central Bank’s two key options at this week’s decision, and yet few would envy Christine Lagarde’s task.

That binary choice of either a half point or an unprecedented 75 basis points of monetary-policy tightening masks an ever-expanding litany of challenges for the president and her colleagues in Frankfurt as they manage a fragile currency area with a war raging next door.

The region’s bruised and uneven economy is beset by a crisis of energy supply, a consequently historic inflation shock, and the impending danger of a subsequent recession. Those challenges grew more acute late on Friday when Russia’s Gazprom PJSC said its key gas pipeline will remain shut off indefinitely.

Officials are also contending with euro weakness, spurred by spillovers from aggressive tightening in the US -- and they know that any ECB move to offset that by raising borrowing costs erodes the fiscal stability of weaker members such as Italy.

While Federal Reserve Chair Jerome Powell’s job of taming rampant inflation in the world’s biggest economy is hardly straightforward, the difficulties his European counterpart faces mean she can squarely claim to have pulled the shorter straw.

“The ECB is walking a very, very fine line,” Emmanuel Cau, head of equity strategy at Barclays Bank Plc, told Bloomberg Television. “The Fed has to slow the economy in order to get inflation down. I think the job of the ECB is much more complex because obviously there’s not much they can do against an energy crisis.”

Thursday’s decision is less complicated than July’s, but no less consequential. Then, the ECB ended eight years of subzero rates with a surprise half-point move and a new tool to shield indebted Italy as borrowing costs rise. A 75 basis-point hike this time would telegraph to investors the increasing urgency in the battle with soaring prices.

What Bloomberg Economics Says...

“A 75-bp increase is far from a done deal and concerns over financial stability will keep some policy makers hesitant. To mitigate some of that risk, an outsized hike would likely be coupled with an emphasis on front-loading.”

--David Powell, Jamie Rush and Maeva Cousin. For the full report, click here

Inflation is at a record 9.1%, with underlying pressures also building. And after a summer that saw Europe’s worst heat wave since the Renaissance, winter is threatening to bring a halt in Russian energy supplies that could cripple the economy and leave families freezing.

“German manufacturers are already shutting up shop because of the high costs,” said Sarah Hewin, head of Europe and Americas Research at Standard Chartered Bank Plc. “For the ECB, this big conflict between tackling higher and higher inflation in the face of an inevitable recession is very difficult.”

While Chief Economist Philip Lane says such a trade-off will be “a major issue,” some colleagues clearly favor stamping out inflation decisively. Several recently suggested a more aggressive 75 basis-point hike instead of simply a repeat of July’s half-point move.  

Inflation data last Wednesday emboldened them further, with Bundesbank President Joachim Nagel reacting within minutes to urge “a strong rise” in rates. Austrian Governor Robert Holzmann told Bloomberg there’s “no reason to show any kind of leniency.” 

Economists at banks from Goldman Sachs Group Inc. to JPMorgan Chase & Co. then changed view to predict the bigger move, as did Bloomberg Economics. Now only a handful of forecasters, including Reinhard Cluse at UBS Group AG, anticipate a smaller hike. 

A 75 basis-point step would match the Fed’s most recent pace, but the nature of Europe’s shock is different. Despite similar rates of price increases, a supply squeeze is the continent’s predominant driver, whereas demand is stronger in the US.  

Since January 2021, more than 6 percentage points in the jump in euro-area inflation reflects energy and food. In the US, it’s just over half of that, according to calculations by Ana Luis Andrade at Bloomberg Economics.

Central bankers know that countering a demand shock with higher rates is far more straightforward than when supply is the driver. Adding to the ECB’s headache, Fed tightening encouraging investors to buy the dollar has pushed the euro below parity with the US currency -- itself feeding inflation through higher import costs. 

“There’s a short window for the ECB to hike, and it’s very much about trying to keep credibility and maybe put a floor on the currency,” said Cau at Barclays, who reckons economic weakness will ultimately curb efforts to raise rates.

The integrity of the currency area is also a worry. Concern is focused on Italy, where this month’s election could install a government led by Giorgia Meloni, whose party’s post-fascist roots have unsettled investors.

Ten-year bond yields there are heading toward 4%. But even that implies a far healthier credit rating than Italy’s level of one notch above junk, assessed by Moody’s Investors Service, according to Colin Ellis, its chief credit officer for Europe, the Middle East and Africa. 

Despite Lagarde being able to deploy her newly developed crisis tool to keep borrowing costs in check, “there remains considerable uncertainty about how this will be used, and in particular how market dynamics will be judged by the ECB,” he said. 

Any decision on its deployment, and on how far rates will rise, will be taken by the 25-member Governing Council, led by Lagarde. The sheer unwieldy size of that body -- more than double the size of the Federal Open Market Committee -- points to another burden.  

The irony is that for all the expectations on the ECB to address inflation, and equally its potential to hurt growth, monetary policy is relatively impotent right now.  

Instead, the Group of Seven agreed to implement a price cap for global purchases of Russian oil in a bid to ease energy-market pressures, while the European Union may put a ceiling on consumers’ bills. EU finance and economy ministers are due to meet Friday, with Lagarde attending, while energy ministers will gather the same day.

“What for instance the EU decides now about unlocking electricity prices, natural gas prices, will probably have a much bigger impact on inflation in the next six months,” said Holger Schmieding, an economist at Berenberg in London. “Interest rates do matter. In normal times they matter a lot, but at the moment they are not quite the key thing.”

More stories like this are available on bloomberg.com

©2022 Bloomberg L.P.