In a widely-expected move, the European Central Bank raised rates from 0% to 0.75% today as its battle against record-high inflation continues. The 75 bp hike is the largest since 1999, pushing the nominal deposit rate into positive territory for the first time since 2011. Now that rates are on the move, the ECB says to expect further hikes at the next “several” meetings.
Central Banks worldwide have been hiking rates to bring down inflation. That’s nothing new.
However, Europe is in a somewhat unique situation — and not an enviable one. 👎
First, the ECB has the fun job of managing monetary policy for the 19 European Union countries that adopted the Euro.
Each of these countries’ economies has its unique set of positives and negatives. For example, Germany is the largest economy known for its innovation and strong export focus. Meanwhile, the derogatory term “PIIGS” represents the weakest economies (Portugal, Italy, Ireland, Greece, and Spain). Moreover, debt levels in these countries have risen to extreme levels, leaving them susceptible to economic shocks and opening the door for another sovereign debt crisis.
In addition to the structural challenges the ECB has to deal with, there are several cyclical challenges it’s currently facing. The most obvious and impactful one is the current energy crisis.
Many European countries relied heavily on Russia for their energy supplies and are now paying the price. In 2021, roughly 40% of gas consumed in the EU came from Russia. The recent conflict between Russia and Ukraine has created a tense situation for everyone involved. And like much of the western world, the EU’s support of Ukraine has come at a significant price. Despite its efforts to procure new energy sources, it’s struggled to fill the gap left by Russian gas. As a result, rising fuel prices have pushed inflation across the EU to record highs. 🌡️
The energy crisis leaves the ECB in a tricky spot because it cannot fix supply-side economic issues with monetary policy alone. It can only impact the demand side of the equation by raising interest rates and tightening financial conditions.
But raising rates in an already weak economic environment could be a recipe for disaster. 😱
Crushing demand with higher rates could push the EU into a recession. And a recession combined with higher government financing rates could cause a debt crisis in overleveraged countries like the “PIIGS.” And if a debt crisis spreads, we’re all in for some pain.
Now there are a lot of “ifs” in there, but given the weakness of the Euro lately, it’s clear investors are worried about the EU’s health. 😨
Lastly, it’s worth noting that many central banks face a similar problem of dealing with supply-side economic issues with monetary policy. For example, the Federal Reserve has said that outright and tells us weekly that it will slow the economy until prices near their 2% target.
They’re all just trying to use their imperfect tools to try and reach their mandate.
How this will all play out remains to be seen, but what’s clear is that the ECB is now kicking policy into overdrive to bring inflation down. Unfortunately, many expect its actions will likely bring their overall economy down with it. 🤷♂️