There are few precedents for the scope, scale and depth of the negative shocks currently facing the Eurozone. On the supply side, the legacy of Covid-19-related disruptions has been compounded by the deepest energy crisis in decades, as the geopolitical fallout from the Russian-Ukrainian conflict materialized and adversely affected European public services. On the demand side, the otherwise strong momentum of last year’s post-pandemic economic reopening is beginning to wane as high and rising inflation reduces disposable income, hurting consumer and business sentiment.
As a result, the eurozone is hit hard by the combination of weak, slowing growth and high, rising inflation.
Consensus forecast for the euro area in 2022
(from January 2021 to September 2022)
Sources: Bloomberg, QNB analysis
This situation creates a particularly difficult macroeconomic context for the development of monetary policy. High and rising inflation is pushing the European Central Bank (ECB) to take a “hawkish” stance and raise interest rates aggressively. Weak and slow growth amplifies the negative consequences of tighter financial conditions as it raises the cost of capital and increases risk premiums between euro countries. This has created a policy dilemma that has so far kept the ECB in a “sluggish” position, lagging behind the US Federal Reserve (Fed) and some other major central banks.
But the ECB’s latest decision to raise interest rates by another 75 basis points (bps) was intended to initiate an aggressive tightening process. This action should have been taken a long time ago because the difference between inflation and policy rates has reached a level never seen in any other historical period. The ECB ignored early warning signals and did not do the necessary “catch-up”. Therefore, the measures to be taken now to narrow the gap between inflation of 9.1% in August and a policy rate of 0.75% must be all the more stringent. In our view, the ECB, like the Fed, but a few months late, has finally embarked on a journey to restore policy credibility, despite the negative effects of the necessary measures on growth. Three main facts support our argument.
Historical inflation and key interest rates in Germany
(y/y, %, 1970-2022)
Sources: Gardens, QNB analysis
First, not only is inflation well above the 2% target in the euro area, but long-term inflation expectations are deteriorating rapidly. According to a flagship study by the ZEW Institute (Zentrum für Europäische Wirtschaftsforschung, Leibniz Center for European Economic Research) in Mannheim, Germany, inflation forecasts for the euro area are around 4.5% in 2023 and 3% in 2024. This is already, and by far, the most severe inflation shock , which the eurozone has experienced in its more than 23-year history. If we take Germany as the benchmark for inflation in the pre-euro period, the last time inflation reached levels similar to August 2022 was in mid-1973. But at that time, the Bundesbank’s key interest rate was at a level corresponding to inflation. This time the gap between inflation and the policy rate is so wide that the ECB still has a lot of catching up to do in terms of rate hikes.
Second, the southern Mediterranean countries or the “periphery” of the eurozone, such as Greece, Italy and Spain, run larger budget deficits and accumulate higher levels of debt than the more conservative economies of the Nordic region (Germany, Austria, Belgium and the Netherlands). As a result, southern European economies are more vulnerable to more aggressive ECB tightening as higher interest rates increase the debt burden, potentially creating an unsustainable dynamic for sovereign debt. The aggressive interest rate hikes decided by the ECB pose a risk of “fragmentation”, an economic spread between north and south within the euro area. To pave the way for further interest rate hikes, the ECB has made so-called “anti-fragmentation measures”. These are measures that allow for the redistribution of additional ECB funds from north to south in the event of renewed tensions due to hawkish monetary policy. We conclude that the ECB is well prepared to continue raising medium and long-term interest rates.
Third, as the gap between US and eurozone policy rates widens, capital flight to the US dollar further weakens the euro. So far, the US Federal Reserve’s interest rate has been between 3 and 3.25%, compared to 0.75% for the Eurozone deposit rate. This increases selling pressure on the euro. Without a significant cycle of ECB rate hikes, the euro could fall further against the dollar, adding to inflationary pressures due to the rising cost of imported goods. In our opinion, this also suggests that the ECB is well equipped to continue its interest rate hikes in order to reduce the interest rate differential in relation to the US.
Overall, the ECB is under pressure to raise interest rates to keep inflation under control, a measure that is more important to the Fed and the ECB than economic growth. Conditions are in place for further aggressive action from now on as inflation picks up. We expect the ECB to raise interest rates again by 75 basis points in October and 50 basis points in December, bringing rates to 2% before the end of the year. We also expect further rate hikes throughout 2023 until the delta between real inflation and interest rates narrows to the point of preventing economic value destruction from negative real interest rates.