The authors are CEO and senior consultant at the financial consulting company Complex
Last week the European Central Bank (ECB) raised the interest rate in Europe from 0% to 0.75, after an increase from minus 0.5% to 0% in July. At the same time, the bank announced that further interest rate increases are expected soon.
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With these moves, the ECB aligns with the sharp interest rate hikes of the other leading central banks in the world, led by the US Fed, and changes a long-standing trend. This, after not raising interest rates since July 2011, and leading a negative interest rate in Europe for eight consecutive years.
Inflation is outside the scope of the central bank’s influence
In the US, the economic situation is much better than in Europe. The Fed is fighting inflation by curbing demand, which stems, among other things, from a hot labor market, which shows a volume of vacancies twice the supply of workers and a historically low unemployment rate of 3.7%.
The interest rate increases in the US are intended to cool the economy and curb the pressures of wage increases and consumer demand, which drive the price increases.
Even in Europe, the unemployment rate is historically low, only 6.6%, but this is not the main factor fueling fears of inflation, which reached 9.1% in annual terms in August. In Europe, the inflation risk stems from an exogenous factor, the sharp jump in energy prices, due to the cessation of gas supplies from Russia and the lack of sufficient alternative energy sources.
The situation threatens not only the energy security of consumers, but also the ability of many factories to continue producing or maintain economic production viability in the face of rising energy costs, and to provide a sufficient supply of products in response to demand.
In the absence of an “out-of-the-box” solution for the flow of energy to Europe from new sources at low costs, a heavy pressure to increase the prices of products and services was created and increased, compounded by inflation.
Now the governments in Europe are facing a difficult dilemma: should they moderate the effect of price increases through subsidies, which could increase inflation by the very flow of money to businesses and consumers? Or to introduce radical plans to limit energy price increases, or to tax the excess profits that will be generated for the energy companies, in favor of transferring them to businesses and consumers in order to mitigate the impact of the high costs? This, while harming the viability of producing and selling energy in Europe, and the principles of the free market.
The big problem in fighting inflation in this situation is that energy costs are not under the ECB’s control, and interest rate increases will not help to reduce them.
The interest rate increases are mainly intended to send a message that the ECB is determined to reduce overall demand in the economy, in order to curb inflation, even at the cost of heavy economic damage.
However, despite the expected damage, the ECB still estimates that a recession will not occur, and expects real growth of 3.1% in 2022, 0.9% in 2023 and 1.9% in 2024.
On top of that, despite the lack of control over the main source of inflation risk, the ECB expects inflation to drop to 5.5% in 2023, and to 2.3% already in 2024, close to the 2% inflation target. In our opinion, these predictions are disconnected from reality.
How is the reduction of the ECB’s balance sheet expected to affect?
At the same time as the interest rate increases, the ECB is expected to discuss this October also the reduction of its balance sheet, which stands at 8.76 trillion euros (similar to the Fed’s balance sheet). The ECB’s balance sheet quadrupled from €2.2 trillion in 2014, when it began government bond purchase programs as part of quantitative easing.
After last July the ECB stopped making new bond purchases and increasing its balance sheet, the next phase of the reduction will be carried out by avoiding the reinvestment of bond receipts that will reach maturity or redemption of bonds on its balance sheet.
Even in the balance sheet sector, the ECB is lagging behind the Fed, which started quantitative easing already in June, first at a rate of 47.5 billion dollars, and starting this month – at a double rate, of 95 billion dollars. For now, the reduction in the US is proceeding without material consequences for the markets.
The president of the ECB, Christine Lagarde, admittedly stated last Thursday that it is too early to start quantitative easing. However, according to estimates, the reduction will begin at the beginning of 2023, because it is necessary to implement the interest rate increases. This is because the central bank cannot push up the short-term interest rate with one hand, and with the other hand to inject demand into the government bond market, which reduces market interest rates, especially in the medium and long term, and distorts the yield curve.
The value of the euro may drop sharply
It is understandable the ECB’s preference to postpone the declaration of quantitative easing, which could contribute to the development of a new crisis in the European government bond market, as in the previous decade.
The bond yields of southern European countries have already recently risen to an eight-year high, after falling sharply in recent years amid the ECB’s massive asset purchases. For example, the yield on 10-year Italian government bonds rose this week to 4%, more than five times the yield a year ago. The continuation of the trend may make it difficult for the Italian government to issue new bonds, and create a debt crisis in Spain, Portugal and Greece as well.
Amid the gloom, there is also good news. The banks in Southern European countries currently hold much less government bonds on their balance sheets compared to the past. Therefore, the risk that a drop in government bond prices will endanger the stability of the banking sector, known as the Doom Loop, has decreased significantly. To illustrate, the Italian banks hold about 6.6% of their assets in government bonds, less than half of the amount they held about two years ago.
On top of that, the fall of the Euro in recent months makes the economies of European countries more competitive and reduces the threat that they will choose to break away from the Union and return to their own currency, which can be depreciated independently.
It is difficult to estimate how much of the future economic deterioration in Europe is already embodied in the battered euro. But in our estimation, the expected decrease in the European GDP and the negative capital movements from the continent, such as due to the outflow of funds from the European stock markets, will continue to damage its value.
To this will also be added the interest differentials against the leading currencies. While in the USA the interest rate is expected to reach about 4% at the beginning of 2023, the target interest rate of the ECB is estimated at 1.5%, against the background of the weak economy.
The interest rate differentials will push investments into the dollar, increasing its value relative to the euro. Therefore, we expect that in the coming months the euro will drop to rates that seemed imaginary in the past, towards 0.9 dollars and 3 shekels.
In conclusion, Europe is facing a difficult economic winter, which combines rampant inflation, alongside interest rate hikes and monetary tightening which have low effectiveness and have exacerbated the recession. This is a particularly dangerous recipe for investors in the old continent.
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