In two days’ time, the ECB’s Christine Lagarde will communicate her bank’s latest interest rate decision. She has an unenviable task in presenting the ECB’s response to an impossible task. Here’s why it’s impossible and here’s how it’s already gone wrong before it’s even started.
All central banks are facing a similar problem, how can we tackle rampant inflation without throwing our economies a few years backwards with respect to their economic output. However, despite a common and familiar enemy, the ECB has a handicap in dealing with the issues at hand. In fact, before it’s even started, it seems the ECB is already running out of firepower to handle the situation.
That might seem strange. For years analysts have been banging on about record low capacity for the ECB to loosen policy, surely now it will instead have capacity to tighten quickly to limit inflation. We have also been talking for years about how the Euro area has a problem of not being able to get inflation up to target, perhaps those same pressures will limit global inflationary pressures in the eurozone? Wrong.
The ECB could choose to trim its balance sheet and offload the bonds it holds accumulated from a decade quantitative easing. However, as observed during the bank’s accumulation of its balance sheet, a vastly disproportionate chunk of these assets are German Bunds. Germany and its populous likely won’t thank the bank for disproportionately destroying its capacity to borrow during this economic malaise. So, de facto monetary tightening via the balance sheet is off the cards.
So how about a good old fashioned raising of the interest rate limbo bar? Once again, the fact that the ECB manages a currency Union becomes a problem. With so many different national experiences to the same source of economic challenge, there are vastly different nationally optimal responses with respect to interest rate adjustment. A bit like with balance sheet manipulation, the ECB may have to adjust interest rates to the capacity of its lowest common denominator, limiting capacity and exacerbating inflationary conditions elsewhere in the group. Good luck Mme Lagarde!
Discussion and Analysis by Charles Porter