Euro Policy Brief – How to Balance Two Dangers


BGA Partners Michael Best and Martin Wiesmann would like to share with you their thoughts on the future path of the Eurosystem’s monetary policy prior to the Governing Council’s monetarypolicy meeting tomorrow.
This time, they explain the balancing act the ECB is currently having to pull off, to avoid a recession and entrenched inflation at the same time.


Unchanged challenges

The turbulence on the financial markets has faded almost as quickly as it arose, and the members of the ECB Governing Council are facing almost unchanged challenges. They have to balance two dangers: If they do too much too fast, they could trigger a recession and new tensions in the markets. If they act too weakly and too slowly, inflation could become entrenched and perpetuated.


In its recent decision in mid-March, the Governing Council showed skill, including in its communication. By raising key interest rates by 50 basis points, the Council avoided sending a signal of concern to the markets. At the same time, it has maintained its credibility in the fight against inflation. Then, in the outlook, emphasising the data-dependency of future decisions was a clever communicative move.


The next decision will be made on 4 May. Shortly before that, on 2 May, crucial data will be available: Eurostat will deliver its flash estimate of the inflation rate in April and the ECB will publish its fresh Bank Lending Survey. If core inflation has risen further, this would be grist to the mill of the hawks, who could push through another 50 basis point hike. However, lending standards will also play an important role in the discussion. If their tightening remains within the extent of what is desired for the transmission of monetary policy, then that would not be an argument against 50 basis points. The doves in the Council, who would like to leave it at 25 basis points and are even flirting with a pause in interest rates, would only have a chance to prevail if the core rate stagnates or declines and lending standards tighten surprisingly strongly, so that the banks do part of the central bank’s job.

We share the view of most market participants that a rate pause as early as May is very unlikely, that 25 basis points is as good as set and that 50 basis points is also possible with corresponding incoming data.


Two schools of thought

As far as the further path of interest rates is concerned, there are two schools of thought in the Council as well as among observers.

Doves argue that if the Council does too much too fast, it risks triggering non-linear disruptive effects that are difficult to control. If, on the other hand, the Council does too little, which could turn out to be the case if second-round effects materialise, then the situation remains manageable, because the Governing Council can follow up at any time. They advocate waiting to see how wages, profit margins and public finances develop and appeal to the social partners, businesses and finance ministers to help curb inflation.

Falcons, on the other hand, stress the danger that high inflation will become entrenched and that inflation expectations will become unanchored. The longer the inflation shock lasts, the greater the risk that this experience will change the expectations and behaviour of economic agents. A further increase and entrenchment of the high inflation rate could be the result. They therefore argue for decisive interest rate hikes as long as there are no clear signs of a decline in the crucial core inflation rate.


Wage growth likely to contribute to inflationary pressure

An important factor for the Governing Council’s assessment of the situation will be wage developments. In its latest projection in March, the ECB staff assumed wage growth in the euro area of 5.3 per cent this year and 4.4 per cent in 2024. In Germany, over the weekend, a settlement was reached in an important collective bargaining dispute. For 2.5 million employees in the public sector, a collective agreement with a duration of 24 months (January 2023 to December 2024) was concluded, which provides for an increase in pay of between eight and 16 per cent, depending on the pay group. The biggest increase will be in the lower incomes, i.e. the incomes of people with the highest propensity to consume. On average, the increase amounts to about 11.5 per cent and is spread over the current year with about 5.5 per cent and over the coming year with about 6 per cent. This indicates that – at least in Germany – wage growth in 2024 will not weaken, as assumed by the ECB staff, but will accelerate.


There are good reasons for this. For employees throughout the euro area will realise over time how large their losses in real income are and will demand tough negotiations from their unions to compensate at least partially for the loss of purchasing power. Widespread labour shortages will also contribute to higher wage and income growth in the coming years than in the past decade. This will increase inflationary pressures from both the demand side and the cost side. At the same time, businesses are trying to build up cushions for future cost increases by expanding their profit margins. We had already pointed out in our policy brief in mid-March that we expect stronger distribution struggles and that this may contribute to inflation becoming persistent.


We are by no means alone in our view. IMF First Deputy Managing Director Gita Gopinath said in an interview published in mid-April in the German business newspaper Handelsblatt that she expects inflation to remain high for several years. Therefore, she now advises countries that fiscal policy must help monetary policy fight inflation. That means tighter fiscal policy. In Germany, this discussion has gained momentum. The governing party FDP argues like Gopinath and thus justifies its call for compliance with the constitutional debt brake in the budget planning for 2024. At the same time, people in Berlin hear behind closed doors that hardly anyone believes that the ECB will be able to push inflation rates down to around two percent by 2025. In this respect, it is also expected that persistently higher inflation rates will push up the nominal national product of the euro countries and lower their debt ratios. This could help to ease the dispute in the monetary union over debt rules. Germany is demanding from its highly indebted partners France and Italy an annual reduction of the debt level by one percentage point, a figure that neither the French nor the Italian medium-term financial plan provides for.


Can markets cope with what is needed?

What was Bundesbank President Joachim Nagel trying to tell us when he recently included the following sentences in a speech at the Peterson Institute for International Economics: “I believe that risks to price stability are currently tilted to the upside. On that note, it is not a given that we will return to price stability over the medium term.” This can be read as a plea for a determined fight against inflation. But it could also be an indication that he expects the economy to face several years of elevated inflation rates because current inflation is changing the future behaviour of businesses, workers and consumers.


It could also be an indication that he considers a monetary policy that brings inflation down quickly with all its might to be unworkable in view of the risks to financial stability. For the worrying question is not: what terminal rate would be needed to push inflation down to around 2 per cent by 2025? But rather: what terminal rate can the markets and the highly indebted states of the euro area cope with? At the beginning of March, the markets’ answer was: four percent is possible.


Currently, expectations are tending towards this level again. We are convinced that the level that will be reached in the summer depends above all on when the core rate starts to fall. If it falls already in April, there will be no more 50 basis point steps by the ECB Governing Council and the terminal rate could reach 3.75 per cent. If core falls in May or June, we could end up at 4 per cent in the summer.

However, this is by no means the end of the story, because in the course of the year it will become clear how strongly the underlying inflation dynamics have taken hold and whether it is enough to simply keep interest rates fixed at the level reached in the summer for a longer period of time, which is what many members of the Governing Council are hoping for.


QT might speed up in Summer

The QT decision of the Governing Council in February will result in the APP portfolio shrinking by 60 billion euros between March and the end of June. The outstanding volume will then still be about 3.18 trillion. In its monetary policy meeting in mid-June, the GC will have to decide on the further reduction path. Hawks in council have emphasised that they could imagine increasing the speed of reduction from July onwards by completely abandoning reinvestment. At the same time, they exclude active sales of bonds.

Looking at the data, one can see that it is not a long way from the current wind-down path to a complete abandonment of reinvestment. From July to December, the APP has bonds maturing for about 150 billion euros. If one were to continue reducing by 15 billion per month, one would not reinvest 90 billion. Hence, the step to no reinvestment at all is no bigger than 60 billion. In view of these figures, it shouldn’t be too much of a hurdle for the majority of the Council to stop reinvestment completely. The APP volume would thus shrink to around 3 trillion euros by the end of the year. Taking into account the approximately 1.7 trillion in the PEPP portfolio, the ECB would hold securities at amortised cost with a volume of around 4.7 trillion euros in its balance sheet at the end of 2023. With such a level of excess liquidity, the balance sheet side can hardly be expected to contribute to fighting inflation.


How can the ECB react if new market tensions arise?

In such a case, the Governing Council would first try to avoid adjusting its interest rate policy and pull all the other cards. Three instruments are available to intervene in the event of tensions in the banking system or in the government bond markets.

In the event of a – in their view – fundamentally unjustified widening of spreads, the reinvestment of bonds from the PEPP could first be calibrated asymmetrically – as was the case last summer. If this is not sufficient, the TPI could be activated. In doing so, however, the ECB’s Governing Council would be treading on politically sensitive ground, because the precondition for activation is a sound economic and fiscal policy of the respective member country of the monetary union. But as long as there is no agreement on new European budget rules, there is disagreement in the political arena on how to assess this.

In the event of liquidity shortages in the banking system, the Council might respond with longer duration tender operations and adjust the collateral framework if necessary. It could also consider narrowing the spread between the deposit rate and the main refinancing rate to 25 basis points. This would make it more attractive for banks to borrow fresh liquidity. In any case, the Council would try everything to smooth turbulences through liquidity operations in order not to have to capitulate in terms of interest rate policy.