With recession looming, ECB may risk fighting
yesterday’s inflation war
Amid fear of a downturn, the euro has hit a 20-year
low against the dollar.
BY JOHANNA
TREECK
July 6,
2022 12:24 pm
FRANKFURT —
Mired in a two-front war against surging inflation and slowing growth, the
European Central Bank may have to reassign its troops.
Just weeks
before the central bank plans to raise rates for the first time in more than a
decade to battle soaring prices, economists warn that a looming recession may
force it change tack again
"Central
banks are embarrassed by having gotten inflation wrong — I think most of us did
— and now want show how committed they are," tweeted EFG Bank economist
Stefan Gerlach last week. "Two wrongs don’t make a right, and I fear this
chest thumping may lead to recession."
Burned by
premature rate hikes in 2008 and 2011 in the midst of the financial and the
sovereign debt crises, the ECB has been slow to react to inflationary
pressures, putting it in a particularly difficult spot compared with its
counterparts, he said.
The Bank of
England has raised interest rates five times, while the Federal Reserve
increased its rates three times, including a giant 75-basis-point move in June.
The ECB's rates, by contrast, have remained in negative territory and are set
to rise by 25 basis points only later this month.
The Institute
for International Finance, which has warned about a looming global recession,
has been calling on the ECB to abort any tightening plans altogether since
early June.
At the
time, central bank staff projections still pointed to solid growth. They saw
eurozone GDP expanding 2.8 percent this year and 2.1 percent in both 2023 and
2024 — projections that increasingly seem too optimistic. A fresh 17 percent
jump in natural gas prices in Europe this week pushed recession fears to front
and center in financial markets.
ECB Vice
President Luis de Guindos acknowledged as much earlier this week. "The downside
scenario in our June projections reflects this risk and implies a contraction
of activity in 2023, following weaker but positive growth in 2022," he
noted.
Berenberg
economist Holger Schmieding is among those who have adopted a more bearish
outlook, and expects eurozone GDP to drop 0.8 percent next year.
"The
ECB is well aware of the worsening risks," he said. "However,
policymakers still seem far away from regarding recession as the most likely
outcome, as we do."
That
sinking feeling
There's no
denying that dark clouds are gathering over the horizon, with fears of a
eurozone recession driving the euro exchange rate to a 20-year low against the
dollar on Tuesday.
Activity in
the manufacturing sector declined for the first time in two years in June, and
a drop in orders across the region suggests the downturn will gain momentum in
the coming months, the key PMI survey showed Tuesday. While the services sector
has kept the economy growing for now, expansion there is beginning to slow as
well.
Meanwhile,
threats to the region’s energy supply could push the economy over the edge,
economists warn. German Economy and Climate Minister Robert Habeck, for
instance, warned last week that the region’s largest economy could face a
complete shutoff of Russian gas by mid-July. Germany’s central bank has
estimated that such a shock could dent the country’s GDP by 5 percentage
points.
Despite
these signs, Gerlach warns that central bankers "almost seem impervious to
this risk," as they remain all too eager to regain their
inflation-fighting credentials.
To be sure,
the ECB's primary mandate is to ensure price stability, which implies that
inflation considerations should trump growth concerns.
But if the
region falls into recession, the risk of currently high and largely imported
inflation feeding through the economy via higher wage demands would drop
sharply — so inflation pressure should abate without a tightening of policy.
Still,
nobody expects the central bank to heed the IIF’s call to abort interest rate
hikes wholesale. Eurozone inflation is still red hot, hitting 8.6 percent in
June and expected to rise further this summer, and the ECB has all but promised
rate hikes for both July and September.
In fact,
the risk of a policy mistake that would see the ECB tightening into a global
slowdown and throwing the currency region into recession is real, Gerlach
warns.
Short of
that scenario, however, economists and investors are starting to scale back
their expectations for the hiking cycle.
"If we
are right with our calls for a eurozone recession, the ECB will have to revise
its outlook substantially again in December," Schmieding said.
"Although inflation at that time will likely exceed the ECB’s current
projections by a significant margin again due to even more elevated gas prices,
the recession should lead to a faster and bigger fall in inflation
thereafter."
Under
Schmieding's forecast, the ECB won't lift its refinancing rate over 1 percent
and its deposit rate over 0.5 percent. The rates currently stand at zero and
minus 0.5 percent, respectively.
The ECB’s
Fabio Panetta, a leading dove, has sought to dampen expectations of a string of
rate hikes, noting last Friday that the central bank had only committed to lift
rates out of negative territory. Any further adjustment, he said, will depend
on the evolution of the outlook for inflation and the economy.
Financial
markets, meanwhile, have scaled back rate hike expectations quite considerably.
At the end of June, they saw an increase of around 300 basis points through
June 2023, but they have lowered that estimate to around 200 basis points this
week.
Some
economists, though, say such an increase is still too bold.
"Markets
continue to price a substantial ECB hiking cycle," IIF chief economist
Robin Brooks said Tuesday. "That'll never happen."
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