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The Olympic motto perfectly encapsulates the challenge facing the European Central Bank (ECB) at present.
Faster, because there is an urgent need to hold back economic activity to prevent ongoing overheating of prices becoming self-sustaining. Higher, because after 10 years in low or even negative territory, key rates have reached levels not seen for more than a decade. And stronger, because the magnitude of the increases announced in recent months is unprecedented in such a short time: 50 basis points in July, then 75 at the meeting on 8 September. This rise of 1.25% in barely two months goes well beyond the guidelines announced last June.
Runaway inflation in Europe
It must be said that the urgency is very real. In August, year-on-year inflation for the eurozone as a whole reached 9.1%. Although some countries are managing to limit the damage by cushioning part of the rise in energy prices through budgetary measures – notably the case in France (6.5%) and Germany (8.8%) – a majority of countries face runaway inflation above 10%, and even above 20% for the three Baltic nations!
A price shock on such a significant scale requires a remedy to match, even if it means knowingly causing economic activity to nosedive, since this is one of the sources of spiking inflation. The ECB's update of growth and inflation expectations speaks volumes on the subject: it is anticipating inflation of 5.5% in 2023, which is far in excess of its medium-term target of 2%. Growth in 2023 is forecast at only 0.9%, down significantly from the 2.1% expected at the start of the summer.
Questionable government measures
The central bank and governments may share the same adversary – inflation – but they do not all have the same weapons to counter it. While governmental measures intended to cushion the energy shock are laudable in social terms, this is more debatable from an economic point of view. By keeping energy prices artificially low, governments are adding to already substantial deficit and debt burdens. And they are also stymying part of the impact of monetary policy by maintaining household purchasing power and lowering business energy costs, and therefore demand. Governments are no doubt implicitly betting that the energy shock is temporary, and so falling into the same trap as the central bankers when they viewed the post-pandemic surge in inflation as transitory.
But for how much longer? The answer could rest with the ECB, because if it were to follow in the footsteps of the US Federal Reserve (Fed) by reducing its balance sheet in the months to come, the upward impact on government borrowing rates would challenge the “whatever it takes” thinking that still reigns in many countries.
Written on 13 September 2022, by Olivier de Berranger, CIO, LFDE