ECB Caught Between a Rock and a Hard Place

Written on 09/03/2022 by Lukman Otunuga, Senior Research Analyst at FXTM

The dilemma of being in a position where one is faced with two equally unwelcome options appears to lie deep in the human psyche. Language has always reflected people’s worries and a quick Google search finds that the phrase in our title originates back to the early part of the 20th century and a financial crisis in the U.S. Fast forward to tomorrow’s ECB meeting and a major humanitarian, trade and inflation crisis has certainly erupted on the borders of the continent.

The Russian offensive in Ukraine has made the economic outlook for the eurozone considerably more uncertain as the fighting goes on. At the same time, we have seen a melt-up in energy and commodity prices meaning that inflation will rise much further in the near term and likely remain at higher levels for longer than the ECB thought only a few weeks ago.

Typically, a central bank would ignore the inflationary impact of an energy price spike stemming from a supply shock. This is because it would have a dampening impact on consumption and actually push inflation lower in the medium term. But now, the rock and the hard place sit squarely on President Lagarde’s mantelpiece.

The ECB is playing catch up after underestimating inflation for more than a year, and also seeing increasing underlying price pressures and a tight labour market. On the flip side, it seems clear that if heightened uncertainty and higher energy prices deliver a major and longer-lasting blow to the Euro-area economy, the ECB will need to continue its easy policies for longer.

In fact, some economists are starting to forecast a potential technical recession in the region. That means two consecutive quarters of negative GDP growth, which several estimate could start at the beginning of 2023. With a war on their doorstep, will consumers go out and spend their savings they’ve built up through the pandemic? Inflation expectations are also surging and now remain clearly above the ECB’s 2% target. This has forced traders into pricing in rising risks of stagflation – the toxic mix of weak growth and high inflation.

With all this to tax the minds of the Governing Council, money markets are still pricing in around a full 25bp interest rate hike by the end of this year. The bank will release their latest staff economic projections which are expected to show softer growth along with higher inflation forecasts. Consumer prices have already been rising at their fastest rate in the 22-year history of the single currency, jumping 5.8% in the year to February. Most economists expect it to remain well above the ECB’s 2% target at least for this year.

A neutral stance is now the call for President Lagarde at her press conference tomorrow. Recent comments from ECB officials have cautioned against repeating past mistakes of tightening policy too early. This means careful steps are warranted as the fallout from the geopolitical events unfolds. This definitely marks a shift in tone from just a few weeks ago when a normalisation of policy and an interest rate rise by the end of the year was forecast.

Will there be some semblance of policy normalisation with added flexibility further out? It will be instructive to see if the already announced rotation of its bond buying programmes continues as planned. All eyes are on you, Madame Lagarde.

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