ECB Rendered Irrelevant By War, Energy Crisis

The ECB delivered a 75bps rate hike on Thursday, but it could’ve just as easily been 50bps. Frankly, it didn’t (and doesn’t) matter.

Like Europe itself, inflation outcomes in the eurozone are hostage to energy and power prices which, unfortunately, are hostage to the Kremlin.

The ECB’s policy rate is now 0.75%. Inflation is 9%. The only thing more comical than that disparity (illustrated in the updated figure, below) is the idea that ECB decisions have any bearing whatsoever on this situation.

In the September statement, policymakers called the super-sized move a “major step” towards “front-loading the transition from the prevailing highly accommodative level of policy rates towards levels that will ensure the timely return of inflation to the ECB’s 2% medium-term target.” You’ll be forgiven for emitting a wry chuckle.

To reiterate: The tragic irony is that the laughable juxtaposition between, on one hand, what the ECB was polite enough to admit is still “highly accommodative” policy, and, on the other, near double-digit inflation, isn’t even the joke here. The joke, rather, is that even if the ECB had hiked 750bps on Thursday (so, add a zero), it probably wouldn’t have much mattered when it comes to the outlook for inflation.

Yes, expectations play a role, as they do in every economy, major, minor, developed, emerging and in-between. But in Europe, those expectations are almost entirely informed by energy prices. How could they not be? Energy prices went parabolic this year. If your electricity bill triples, the rest is irrelevant. And the ECB has no control over energy prices.

On Thursday, the bank said they’ll likely raise rates further “over the next several meetings” in to order to “dampen demand.” Again, you can’t help but chuckle. I can promise you that demand will “dampen” itself in the event governments aren’t successful in capping power prices for consumers. If this winter is especially cold, and people are forced to go without sufficient heat either because they can’t afford it, because it’s not available or both, there won’t be any demand for discretionary purchases and a deep recession will ensue. Of that, I’m absolutely certain.

But in such a nightmare scenario, it’s far from clear that inflation expectations would re-anchor. That depends almost entirely on whether consumers believe governments have a handle on the provision and pricing of energy and power. Exactly none of that is the ECB’s purview, and like so many candle-burning Europeans in a worst-case winter scenario, policymakers will soon be compelled to confront their own powerlessness.

The ECB’s new forecasts (figure below) are a joke. I don’t normally resort to that kind of naked derision, but I’m not sure how else to describe the new projections. Staff revised 2022’s inflation forecast higher, but it’s a full percentage point below August’s realized level — with the Nord Stream totally closed. The out-year forecast was revised slightly higher, but at just 2.3% for 2024, it seems very optimistic, and really, you could argue it’s also pessimistic in the sense that it shows the ECB is no longer confident they can return inflation to target over the medium-term.

On the growth front, it’s hard to know what to make of the projections. The ECB expects the bloc’s economy to expand 3.1% this year, up from June’s projection. Next year’s forecast was revised sharply lower, but the bank still expects a 0.9% expansion — during what’s guaranteed to be the most challenging year for the bloc since the sovereign debt crisis. Germany is facing a severe recession. It’s very difficult to understand the bloc-wide forecasts in that context. They’re not so much wishful thinking as they are a fantasy.

The outlook for inflation and growth in Europe is now in the hands of fiscal policy, which isn’t exactly comforting considering this is a monetary union without a unified fiscal framework or even a reliable mechanism by which unified fiscal policy is possible. The fiscal burden-sharing discussion comes up time and again, and there have been breakthroughs (e.g., during the pandemic). But what’s needed currently is sweeping, top-down industrial planning — a war footing — with no room for argument or defection. To call that far-fetched in the European context is an understatement.

In the earliest days of Vladimir Putin’s “special military operation” in Ukraine, I assumed European officials had a contingency plan, although I don’t know why. The pandemic made it abundantly clear that governments don’t, in fact, have contingency plans for existential crises. It was always possible that Putin would one day decide to weaponize Europe’s dependence on Moscow for natural gas, which means European governments should’ve run stress tests aimed at quantifying the ramifications for regional power markets of a worst-case scenario. I’m sure some such scenario analyses were, in fact, conducted, but it scarcely matters if such exercises don’t translate into contingency plans.

Now, it’s far (far) too late. The ship hasn’t just sailed, it’s circumnavigated the Earth. Europe is experiencing an acute cost of living crisis, and the flagging euro is making things much worse. Europe is importing inflation, and the attendant terms of trade shock (figure below) is exacerbating downward pressure on the currency in a macro doom loop.

The ECB is mostly bereft when it comes to addressing that even with rates. There’s no prospect of Christine Lagarde “matching” the Fed, and thereby no real way for monetary policy to support the currency and short-circuit the trade shock.

It’s not obvious that the neutral rate is relevant at this point, but assuming it is, neutral for the ECB is probably at least two full percentage points below terminal for the Fed. Seen in that light, and assuming little, if any, relief on the growth front, the euro is a sitting duck, if readers will forgive the colloquialism.

“For those who consistently repeat that the European Central Bank is lagging behind, I contend that we are on a journey that started back in December when we decided to put an end to asset purchases under PEPP,” Lagarde said Thursday.

It’s not so much that the ECB is “lagging behind.” They clearly are, but that’s not the real problem. The real problem is that due to the nature of the shock, it’s literally impossible for the ECB to get ahead.