The ECB must act quickly to avoid a monetary crisis
The euro has fallen steadily over the past year, falling from above 1.22 to the dollar to near the low of 1.0640 in March 2020 when the pandemic first hit. A parity test against the dollar later this year is no longer a low probability risk. A monetary crisis of confidence is the last thing the European Central Bank needs. It already faces an almost impossible choice between thwarting the surge in imported inflation or risking another recession. But doing nothing quickly ceases to be an option.
Imported inflation is exacerbated by the war in Ukraine because much of Europe’s energy purchases are denominated in dollars. A weaker euro only amplifies the problem in the short term. This is the reverse of the situation for most of this century, when an arguably undervalued common currency boosted exports to China and Russia. These trading partners are either shut down suddenly or suffer their own economic downturn. It doesn’t help when the US Federal Reserve appears to be on a mission to raise interest rates at the fastest pace in decades to combat its own inflation spurt. The negative rate differential in Europe is glaring.
The only logical answer is for the ECB to raise its official deposit rate from the current super-stimulating 50 basis points. But it must also cautiously maintain loose financial conditions through other monetary tools, such as bank lending incentives. While bond yields have risen several times in Europe relative to Japan, the ECB has yet to offer significant support for the euro. Something has to give and the first step is to stop its QE bond buying programs in early summer and pave the way for the first rate hike in September.
Unfortunately, at last week’s Governing Council meeting, he chose to do nothing but buy time until the next quarterly economic review on June 9. 2%. The council didn’t even discuss the currency (although Lagarde said she and her colleagues were “attentive” to it, whatever that means). The market could tell that the ECB was avoiding the problem, hence the further weakness in the euro.
Maybe the ECB will get away with it. But let’s be honest here: postponing rate hikes often precipitates a deeper crisis. The weak link in the chain is no longer the peripheral bond spreads from countries like Italy or Greece to Germany’s European barometer. It is the euro itself. Lagarde speaks twice this week and must clarify the timetable for reversing the overly generous pandemic stimulus that is contributing to soaring inflation. A CPI annual rate of 7.5% in March requires action, not lame epithets that the Governing Council will act if necessary. When will he know things are broken? With double-digit inflation?
Europe has so far been lucky. The current presidential race between Emmanuel Macron and Marine Le Pen hasn’t affected markets the way it did when they first faced off in 2017, when bond yields rose sharply. French. There have not yet been any sharply rising wage demands. But the ECB cannot delay hoping for divine providence. As the Fed and the Bank of England have understood, unless the monetary policy response is swift and aggressive, markets will quickly lose confidence. This is a risk that the ECB can no longer take. It needs to raise rates this year and clearly telegraph its expected actions. Otherwise, his already ingrained problems will get worse.
More from Bloomberg Opinion:
Zero is a good destination for ECB interest rates: Marcus Ashworth and Mark Gilbert
High inflation sets in for the long haul: Jonathan Levin
• Dethroning King Dollar won’t be easy: Robert Burgess
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in banking, most recently as Chief Market Strategist at Haitong Securities in London.
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