ECB policy: Time is short, decisive action is required

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After several consecutive months of record-high inflation levels, the European Central Bank (ECB) reacted in July and hiked interest rates for the first time in more than a decade. But how is this step to be evaluated? And how does it continue?

“The interest rate hike of 50 basis points decided in July is a step in the right direction,” says Dr. Andrea Siviero, Investment Strategist at Ethenea Independent Investors. “However, the situation remains particularly challenging for the ECB as it is caught between the risks of stagflation, recession and political tensions within the eurozone.”

A difficult task

The task of the ECB is extremely difficult for several reasons: Firstly, European inflation is mainly caused by high energy and commodity prices, and tighter policies have little impact on containing costly inflation. On the other hand, a tightening of politics in a slowing environment harbors increased risks of recession. “Furthermore, national debt levels are strained and there is little willingness for coordinated fiscal support at the eurozone level,” explains the investment strategist. Finally, interest rate hikes in the eurozone would not enjoy broad political support, and given the region’s economic disparities, aggressive tightening could lead to undesirable market fragmentation in the eurozone bond market.

Overall, the European economy has not recovered from the pandemic-induced recession as quickly as the US economy. “The eurozone has been hit hard by the conflict in Ukraine because of its dependence on Russian energy,” says Siviero. Consumer confidence is falling, manufacturing is suffering from supply shortages as a result of the Covid outbreak in China and the economy is slowing.

Price stability remains the main task of the ECB – and time is of the essence

Nevertheless, the expert believes that the ECB should continue to act decisively and be guided by its mandate to maintain price stability. “The primary objective of the ECB is price stability. On the other hand, support for economic measures in the Union should only be given to the extent that they do not affect the objective of price stability,” says Siviero. “In this regard, the current record level of inflation fully justifies the ECB’s decision to act urgently and decisively to curb record inflation.”

In the current situation, the ECB could not wait any longer: “Further delaying its action would unnecessarily prolong the current damaging stagflation environment and delay its tightening cycle, hurting European citizens – especially the most vulnerable ones – and exacerbating social tensions, without a tangible response to the.” inflationary environment,” says Dr. Siviero to consider.

A weak response to record high inflation would also irreparably damage the ECB’s credibility. “Loss of credibility can be very costly for central banks as it can force them into longer and more painful tightening cycles,” explains the investment strategist. “The ECB should therefore send a clear signal that it does not accept inflation becoming entrenched.” Siviero expects the ECB to continue to act decisively in order to manifest inflation expectations.

“The ECB has no specific exchange rate target, but the recent rapid depreciation of the euro is hurting the inflation outlook and hurting European consumers,” says Dr. Andrea Siviero. The divergence in monetary policy measures is one of the main reasons for the weakening of the euro. Resolute action by the ECB could contribute to a stronger euro and thus protect the euro zone from a further acceleration in inflation.

“The time window for the ECB is closing,” emphasizes Siviero. The ECB is lagging behind the major central banks in the fight against inflation and would be well advised to further tighten policy in the coming months in order to gain the necessary policy space to face a looming recession or future exogenous shocks.

Conclusion

dr Andrea Siviero sums it up: “The eurozone was created with the original sin of a common currency for countries with different economic performances, which are guided by national interests. However, the ECB should not feel responsible for the structural weaknesses of the European construction. Rather, it should focus on its price stability mandate and make the right decisions for the benefit of European citizens.”