1. The delay and the gap from the USA
Elegantly late, and when inflation in the Eurozone already reaches 9.1%, the European Central Bank (ECB) on Thursday raised its interest rate to 0.75%, far behind the rate of inflation, it is no wonder that Christine Lagarde, the president of the bank, is talking about a series of interest rate increases that Waiting for the future – more than two (including the current one) and less than five.
Lagarde emphasized that the policy will be determined according to the data on the ground. According to the bank’s forecasts, inflation will stand at 5.5% (!) next year, and according to sources in the bank’s board of governors, who were quoted this week by Reuters, the interest rate is likely to rise above 2%, to a level where it will “restrain” activity in the Eurozone. In the meantime, activity in the Eurozone is slowing down anyway and according to Lagarde it should enter a “stagnation” later this year and this is just the bank’s basic reference scenario. Lagarde also mentioned a negative scenario in which the Eurozone will enter a recession in 2023.
The ECB’s sharp interest rate hike is a form of alignment with the Federal Reserve, the American central bank, which has already raised interest rates twice this year at a rate of 0.75%, and whose chairman, Jerome Powell, continues to signal a dovish direction even ahead of the interest rate announcement this week the next.
Still, Europe is not the United States. In America, Lagarde explained, inflation is mainly a matter of high demand that pushes prices up. In Europe, it is mainly a matter of supply – as it aims at a spike in gas prices following the war in Ukraine.
If in the US, the Fed talks about the “pain” that will be caused in trying to lower inflation. In Europe, which is slowing anyway, it seems that Lagarde’s task will probably be more painful.
But there is another factor that complicates the situation even more, and it was emphasized at the end of the week by Nobel laureate economist Paul Krugman. In the US, polls show expectations for inflation to moderate within 5 years. But in Europe, inflation expectations are only increasing on average. In the eyes of central bankers, inflation expectations are considered a kind of self-fulfilling prophecy, which leads Krugman to state that there will be particularly painful decisions in Europe.
2. A currency war is necessary
The euro recently fell to a low of less than one euro to the dollar (and rose again following the interest rate decision). Lagarde emphasized that the European Central Bank is not trying to influence its currency rate, and immediately shot data on the currency rates: the euro has weakened by 12% against the dollar since the beginning of the year, “and of course we are paying attention to that.”
Whether or not the European Central Bank is trying to directly influence its exchange rate, the dynamics are clear. The dollar strengthens against other currencies in the world, contributing to local inflation in these economies. This dynamic led Prof. Maurice Obstfeld, the former chief economist of the International Monetary Fund, to warn this weekend against an “unnecessary global recession”, which will be created as a result of uncoordinated policies of the central banks “which actually export inflation to their trading partners, through actions that strengthen their currencies”. . But Obstfeld also emphasized in the research he presented, that if the US did not act to curb its inflation, it would only add to the destabilization of the global market.
3. The ambitions of Kyiv
A difficult winter is expected for Europe, and the governments on the continent are formulating aid programs designed to help citizens deal with the high energy bills – which will deepen their national debts, and make it even more difficult to curb inflation. In the background, as mentioned, is the war in Ukraine, and Moscow’s decision to dramatically reduce the flow of gas to the continent. It may also be hovering over Ukraine’s counterattack, which broke through Russia’s defense lines near Kharkiv at the weekend: results need to be shown.