ECB tries to reconcile rising inflation with war risks

Small figures can be seen in front of the displayed word “Inflation”, the EU flag and the rising stock chart in this image dated February 11, 2022. REUTERS/Dado Ruvic/Ilustration

March 10, 2022

By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) – The European Central Bank is likely to minimize policy commitments on Thursday as the shock of Russia’s invasion of Ukraine upends its expectations for the economy and policymakers are confronted with new realities.

With euro-zone inflation already at a record high before Moscow’s attack began on February 24, policymakers had been expected to announce the end of years of money-printing stimulus and pave the way for a rate hike later this year .

But the war has shattered that consensus, and the 25-member ECB Governing Council will go to the meeting divided, increasing the likelihood of a policy surprise – and the risk of failure.

“No one can seriously expect the ECB to start normalizing monetary policy at such a moment of high uncertainty,” said ING economist Carsten Brzeski.

The safest course seems to be for the bank to confirm an earlier decision to further taper bond purchases in the next quarter while leaving all other commitments, including an end date for purchases and the timing of a rate hike, up in the air.

“We believe the ECB will aim to buy some time by proceeding with the previously planned phased taper in April…while increasing flexibility in forward guidance to allow for more room to maneuver once the immediate fog lifts said Societe Generale economist Anatoly Annenkov.

“As long as we avoid a recession, which is our current baseline, we expect the ECB to conclude later this spring that monetary policy needs to tighten more quickly to stabilize inflation expectations.”

Inflation in the 19 countries using the euro could reach three times the ECB’s target of 2% this year and is likely to remain elevated next year.

A rebound in economic growth and the tightest labor market in decades should also prompt the ECB to abandon its ultra-loose monetary policy stance and end a nearly decade-long experiment in unconventional stimulus.

The Federal Reserve is sticking with its plans to raise US interest rates next week and is announcing a series of hikes in the cost of borrowing as inflation rises.

But the conflict in Ukraine, the unprecedented sanctions western countries have imposed on Russia and soaring commodity prices will all increase uncertainty, dampen growth and weaken household spending power, contributing to caution.

However, some political hawks are likely to urge the ECB to rein in stimulus and at least return policy to a “neutral” stance, allowing the bank to signal the end of asset purchases in the coming months, a decision that raises the odds of – but would not cement – ​​a rate hike in 2022.

The bank is also expected to drop any reference to a rate cut in its forecast and possibly remove a stipulation that a rate hike would come “shortly” after bond purchases ended.

STRUCTURAL CONCERNS

Even if the can is kicked in the street on Thursday, high inflation makes the stimulus rollback almost inevitable, but the real problem is how a shifting world order will affect prices far away, a time horizon that the ECB is more relevant.

High energy prices will dampen growth and could slow inflation in the longer term as families spend less on other things and businesses defer investment.

For this reason, the ECB’s inflation forecast for 2024 is unlikely to deviate much from the 1.8% it forecast three months ago.

These forecasts have been so unreliable in recent months that policymakers are now openly questioning them, making them less relevant to decision-making.

The war in Ukraine is also likely to unleash economic forces that could further push up prices.

Increased defense spending, as outlined by several eurozone members, and a quick green transition to wean the bloc off Russian gas should boost government spending and inflation.

These could also be backed by joint issuance of European Union debt, and the bloc would likely expect the ECB to keep its borrowing costs low.

However, it is next to impossible to quantify the inflationary costs of these long-term decisions, so the ECB forecasts will not reflect them, even if policymakers are likely to bring them up in the debate.

(edited by Catherine Evans)