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The ECB doesn’t seem to have learned the lessons from its own past

The ECB long held the view that inflation risks were primarily tilted to the upside, which, it believed, warranted pre-emptive policy action. It changed course under the leadership of Mario Draghi to avert the threat of secular stagnation, but now it seems to be reverting to hawkish type once again despite the threat of recession overhanging Europe. We believe it could be on the verge of a costly mistake.
Willem Verhagen, Senior Economist, Multi-Asset
NN Investment Partners, 15 March 2022
  • The ECB is persisting with its hawkish stance
  • Russia's invasion of Ukraine has increased the risk of recession in Europe
  • We believe the ECB is at risk of making a major policy mistake


The ECB long held the view that inflation risks were primarily tilted to the upside, which, it believed, warranted pre-emptive policy action. It changed course under the leadership of Mario Draghi to avert the threat of secular stagnation, but now it seems to be reverting to hawkish type once again despite the threat of recession overhanging Europe. We believe it could be on the verge of a costly mistake.


The ECB was designed to focus on upside inflation risks

The ECB was established in 1999 as a central bank that was focused on upside inflation risks, which were believed to be part and parcel of the economic environment the ECB was operating in at the time. It’s important to remember that the ECB was modelled upon the German Bundesbank, which was much more successful than most other developed market central banks in fighting inflation in the 1970s and 1980s. The Bundesbank reacted forcefully and pre-emptively to the oil price shocks of 1973 and 1979, by and large preventing a wage-price spiral from developing in Germany.  

By contrast, many peripheral European countries were struggling with a long-lasting inflation bias well into the 1990s that was rooted in fiscal and monetary policies that were persistently too loose. As these countries found it difficult to muster the internal discipline to commit to a tighter policy mix, they opted for externally imposed discipline by linking their currencies to the Deutschmark. However, these exchange rate pegs were not fully credible, especially when the economies in question were weakening and the maintenance of the peg required monetary policy to be tightened. Several exchange rate crises later, European countries decided to consign such events to history by pegging their currencies irrevocably in a monetary union guarded by an independent central bank.


…but the world around it changed profoundly

ECB decision-makers in the early 2000s were to some extent justified in believing that their job was to tighten pre-emptively in the face of any shock that caused headline inflation to rise, such as a commodity boom or fiscal easing. As for the latter, monetary tightening automatically disciplined fiscally profligate governments by increasing their borrowing costs. The only problem was that the underlying economic backdrop had gradually changed from how it was in the 1980s into something very different. For instance, decades of low and stable inflation combined with a large reduction in workers’ bargaining power had resulted in well-anchored inflation expectations. As a result, a commodity boom no longer automatically spilled over into a wage-price spiral. Instead, its inflationary effects died out of their own accord. 

Meanwhile, entry into the Economic and Monetary Union made role models of several (but not all) peripheral countries – most notably Spain and Italy – for their fiscal frugality. Because of this frugality, they no longer needed higher borrowing costs to impose discipline upon them. More importantly, after the peripheral credit-driven housing bubble, which was fuelled by capital inflows from the core, burst in 2009, peripheral countries needed a combination of fiscal and external demand support. They received neither because panic in the financial markets drove their yields sky-high in 2011–12, while the core countries managed to enforce concerted fiscal austerity over the entire region until the 2010s.


After two policy mistakes the ECB adapted to the new regime

In the immediate aftermath of, and indeed the years following, the Great Financial Crisis the ECB stubbornly stuck to its line that inflation risks are always on the upside. It was for this reason that it hiked rates in mid-2008 when it was clear that a global credit crunch was already brewing; it did so because it feared that the sharp rise in oil prices at the time would trigger a wage-price spiral. And in 2011, when the Eurozone sovereign debt crisis was already gathering steam, the ECB once again raised rates in response to higher oil prices. This turned out to be the financial equivalent of throwing a lighted match into a warehouse of fireworks. 

It was only when Mario Draghi became ECB President in 2011 that the central bank started to acknowledge that the world had changed. First, it recognized that it should act as a (conditional) liquidity backstop for governments to short-circuit any panic-driven liquidity droughts in the sovereign bond markets. It is hard to overstate how important this has been for the survival of the monetary union. Second, it recognized that the region was heading towards secular stagnation, which meant the risk to inflation was persistently on the downside. This resulted in the introduction of quantitative easing to cement the bank’s commitment to keep yield curves low for a long time. 

The hawks within the ECB offered strong and vocal resistance to the changes that Mario Draghi implemented, but they were always in a (albeit sizeable) minority. However, the current inflation spike has enabled them to seize the initiative and convince their more moderate colleagues that upside inflation risks are back. This has undoubtedly been made easier by Christine Lagarde seemingly preferring to accept the consensus view than Mario Draghi, who was driven more strongly by his convictions.


The Ukraine shock is likely to result in downside risks to growth

It’s highly doubtful if the upside risks to inflation are greater than the downside risks at present. Even before the Ukraine crisis the increase in Eurozone inflation was mostly due to higher energy and import prices; in other words, it was a negative terms-of-trade shock that was reducing overall real income in the region. There is nothing that monetary policy can do to alleviate this kind of effect. In fact, tightening in response to a negative terms-of-trade shock only serves to reinforce the decline in real income. Such a price is only worth paying if there is evidence that the shock is triggering a wage-price spiral. 

The Ukraine conflict has strengthened short-term stagflationary trends significantly. There is in fact a risk that a bigger and more prolonged inflation spike will cause a wage-price spiral, but the ECB has the luxury of being able to wait until it sees clear evidence of such a spiral emerging before it needs to act. After all, inflation expectations have only just begun to re-anchor themselves after being well below target for years, while wage growth is still well below the 3% mark consistent with price stability. 

In our view, the bigger risk is that the Ukraine conflict will have a negative impact on growth that exerts downwards pressure on the core inflation outlook over the medium term. With nominal wage growth still low, households are likely to experience a sharp decline in their real disposable incomes, which will weigh on their confidence and willingness to spend. Meanwhile, businesses are confronted with a sharp increase in uncertainty, which, in combination with pressure on profit margins, is likely to weigh on investment spending. All these effects could be amplified by a further tightening of financial conditions.


The March meeting: hawkish optionality and little news on flexibility

Ahead of the ECB’s March meeting the keywords were optionality (the ability to react to changes in the inflation outlook) and flexibility (the ability to act as a liquidity backstop for sovereigns). The ECB created optionality by accelerating its tapers, with the effect that net asset purchases are now expected to end in Q3. The first rate hike will come “some time after” that. Both the updated inflation forecasts (2.1% in 2023 and 1.9% in 2024) and the ECB’s statement that it “sees it as increasingly likely that inflation will stabilize at its 2 per cent target in the medium term” reveal that the implied optionality is of the hawkish variety. It will take a large negative surprise relative to the ECB’s baseline scenario, such as a sharp downturn in growth or significant tightening of financial conditions, for the central bank to deviate from its policy normalization plans. 

The end of the pandemic emergency purchase programme (PEPP) this month and the accelerated taper will weaken the ECB’s liquidity backstop for sovereigns at a time when the Ukraine conflict is forcing governments to ease fiscal policy and step up their investments in defence and energy independence. The ECB has promised to use PEPP reinvestments flexibly to prevent excessive spread widening, but this is unlikely to be enough if peripheral spreads once again become the victim of a panic-driven liquidity drought. 

In summary, the ECB once more intends to gear its policy setting towards the risk that a commodity-driven inflation shock will trigger a wage-price spiral – even though the risk of such a spiral developing is arguably even more remote than it was in 2008 and 2011. Both times, similar policy reactions turned out to be huge mistakes. In our view, the ECB is essentially ignoring the growing risk of recession hanging over Europe due to the Ukraine conflict. Much like in 2008 and 2011, this blinkered view could turn out to be rather costly.