Investors bet against Europe – let’s hope they’re wrong – The Irish Times
There was a time when central banks liked to surprise the markets by changing interest rates. Now central banking is all about forward guidance and preparing the way, so we know the European Central Bank will raise interest rates next week. But the bank’s board is a house divided, struggling to demonstrate that it has any prospect of controlling inflation as the eurozone economy potentially heads into serious trouble.
Investors are betting against Europe at the moment, selling European assets and the euro itself and nervously watching political developments in Italy. Investors have taken big bets against the euro and are now eyeing Italy’s public debt as Mario Draghi’s coalition falters. Markets believe recession is approaching in the Eurozone – and it will come if Russia’s gas supply is cut off, although we don’t yet know if that will happen.
In the middle of this maelstrom is the ECB, where President Christine Lagarde leads a clearly divided Governing Council whose members disagree on what to do about rising inflation. It is under attack for being “behind the curve” as the Bank of England and the US Federal Reserve are already raising interest rates. But while higher interest rates will dampen economic growth and have a longer-term impact on inflation, they do nothing to stop the immediate pressure on prices, which comes from rising oil costs. energy, other commodities including food, and messy global supply chains. .
Central banks therefore face major credibility challenges in their desire to control inflation. For years after the financial crash, they failed to bring inflation back to their target level of around 2%, despite massive monetary expansion. Now they are faced with the opposite problem: how to withdraw the massive stimulus package to bring inflation down without worsening the economic dislocation.
Doing this as the recession looms and in the midst of a cost of living crisis will be tricky to say the least. At a time when major institutions are battling to retain greater public trust, central banks face a daunting test. They must persuade the public that they can reduce inflation, because public expectations are key in determining what happens. But people are more likely to be swayed by their gas bill, supermarket store and the cost of filling up the car. If they raise interest rates just as economies are tipping into recession, they risk being blamed for forcing higher unemployment and economic hardship. And in today’s populist era, they will be hammered home as part of the “elite establishment” who don’t care about ordinary people.
Central banks will look for a middle way through this. But maybe there just isn’t. Having failed to persuade people that inflation was going to rise for years, central bankers are unlikely to be the ones to persuade them that it will fall from its current stratospheric levels. If growth collapses but inflation remains high, then we have a central banker’s nightmare: stagflation and a permanent political dilemma.
As if all this were not enough, the ECB faces another job. This is to stop speculation plaguing eurozone government bond markets, driving up the cost of borrowing for vulnerable countries – with Italy first in the line of fire. With a high debt level and the need to accelerate growth, Italy is the country most vulnerable to market speculation. Now the threat of collapse of the Italian government of Mario Draghi has raised the stakes. Strikingly, whoever declared in 2012, as President of the ECB, that the bank would do “whatever it takes” to save the euro is now at the center of the latest drama.
The tough ones
If Draghi’s government collapses, Italy’s economic program, needed to tap into vital European funds, will be in jeopardy. And its cost of borrowing – which has already jumped more than two percentage points above Germany in recent weeks – could rise further. The ECB has promised to come up with a new “instrument” to combat this kind of speculation and more details are expected after Thursday’s meeting.
But here again, the ECB council will be divided. Hardliners on the ECB board – led by the Netherlands, Germany and Austria – favor allowing higher public borrowing costs to impose economic discipline countries and will insist on strict conditionality via budgetary pledges for any special market support from the ECB. You can imagine how this – with its echoes of the last financial crisis – would sell in Italy amid what could be an election campaign.
For Ireland, a European recession, as Paschal Donohoe warned this week, is a worrying prospect, as are skyrocketing gas prices and supply threats that would cause it. Ireland’s economy emerged from the Covid shutdowns in remarkably good shape and surged in the past year. But consumers are now being battered by rising prices and overseas markets are slowing. Economic data from the first quarter suggests that the growth of the domestic economy has already slowed and export markets are also expected to be affected in the second half.
Rising interest rates will also impact households and national finances, although Europe’s weak growth outlook could mean less dramatic ECB hikes later this year than expected. One of Ireland’s main objectives must be to stay out of the market if tensions mount in the euro zone.
After years of relative calm in the wake of the financial crisis, everyone is still trying to tame the new era of instability. It creates real short-term problems and puts longer-term problems, including climate change, on the back burner. In the midst of this, the ECB appears to face an impossible task at its meeting next week. It could be a messy fall.