Will the ECB manage to reduce inflation… without a crisis?

As the ECB initiates a more restrictive monetary policy, the question is whether the euro zone is exposed to a risk of crisis. The Italian 10-year rate is thus close to 4% (unheard of since 2013!), a level that is difficult to sustain for public finances. At the same time, the interest rate differential between the various countries of the euro zone is maintained in a context of crisis in the balance of trade. This situation, delicate to say the least, requires the ECB to exercise great caution. However, the fight against inflation is an absolute imperative, but the European institution has been significantly slow to react. Real rates have never been so low. Investors and savers see their assets devaluing. In our previous article, we discussed the recessionary risks that would occur in the euro zone (The recession is looming in the euro zone – Tremplin.io). Deciphering a tense and decisive situation…

The ECB on the way to the Fed

The fight against inflation is clearly redefined as a priority after the meeting of the various moneymakers of the world in Jackson Hole. The euro zone can no longer wait macabre for the devaluation of the euro without reacting. Since January 2021, the euro has lost more than 19% of its value against the dollar. The fact that the euro is at its lowest point since its release and that the ECB is particularly slow to raise rates have created major tensions for the euro zone economy.

Inflation (red), ECB key rate (black), and European Central Bank balance sheet (blue). Source : ECB lifts rates by unprecedented 75 bps to fight inflation | Reuters.

Consequently, the imperative of monetary stability appears more vital than ever. The first step for the ECB was to definitively exit the negative rates in place since 2015. From now on, the rise in rates can accelerate. At its meeting held today, the ECB was expected for a rate hike of 75 basis points. Which has obviously been confirmed. In addition, the objective set by the ECB would be to reach a key rate of 1.3% by the beginning of 2023. The key rate would then rise to 1.8% by 2024.

“The median (and majority) expectation was that the rate on the Eurosystem’s main refinancing operations would increase steadily, from 0.5% in the third quarter of 2022 to 1.3% in the first quarter of 2023. Interest rates should average 1.5% (vs. 0.6%) in 2023 and reach 1.8% (vs. 1.0%) by 2024 (see Chart 15a). » – European Central Bank – The ECB Survey of Professional Forecasters – Third quarter of 2022 (europa.eu).

Consequences on the financial markets

In the wake of the ECB’s monetary policy expectations and announcements, the euro crossed parity again. After a low on Wednesday at 0.99 euro for one dollar, the EUR/USD exchange rate has returned to the bar of 1. This may sound like the start of a medium-term euro rebound. Nevertheless, the amplitude of the rebound movement of the euro aroused remains weak…

For their part, the financial markets remained stable to finally plunge into the red in the middle of the day. In addition, investors remained cautious and hedged against the central bankers’ announcement on Thursday. Finally, the ECB’s announcement weighed on the indices slightly and confirmed the prospect of an additional restriction on available liquidity.

For its part, bitcoin (BTC) fell slightly (by almost one and a half percent during the day). The announcement of new monetary restrictions always negatively impacts the most volatile financial assets. However, the announcement of the ECB’s restrictions does not surprise the market and is part of the logical continuation of the rate hike in the United States. Safe havens, such as gold, have finally followed the same trajectory. Gold fell relatively low from near $1725 an ounce to below $1715 an ounce. This fall is more marked on the price of gold in euros, despite the fact that gold remains on its supports which validate a price of the yellow metal close to its historic highs.

In short, equities, gold and bitcoin are down slightly after the ECB announcements. Conversely, the euro seems difficult to confirm short-term lateralization…

Inflation (still) on the rise in the euro zone

Recently, the figures of inflation in the euro zone in August over one year reached 9.1%. Indeed, this figure is up by 0.2 points compared to the previous month. In Europe more generally, inflation is +2.5% over one year in Luxembourg. It is also +3.5% in Switzerland. France appears in 3rd position with relatively “moderate” inflation at +5.8%. In the case of Switzerland and Luxembourg, the presence of a high standard of living, the stability of the Swiss franc or supply chains explain the low inflation.

Inflation in the euro zone (1995-2022). Source : Eurozone – Consumer Price Index (CPI) (investing.com).

But the situation is much worse in the Baltic countries. Thus, the worst inflation is that recorded in Estonia, Latvia and Ukraine. Inflation in these three countries is respectively close to +25% in Estonia, +22.4% in Latvia, and +22.2% in Ukraine. The countries of North-East Europe pose a serious problem for the ECB. Indeed, there are huge differences in inflation rates within the same monetary zone. Between Luxembourg and Estonia, inflation is 10 times greater!…

Finally, in some countries like Turkey, inflation exceeds +80% over one year. The risk is that this contagion will spread to part of Europe. Inflation quickly gets out of control in history past ten percent…

What concrete impact on the economy?

The economy is poised for a rate hike in the eurozone. But this is not the case for States and public administrations which are confronted with the carelessness of political decisions. The size of the deficits and public debts prevents the States from supporting a sufficient rise in rates. Thus, the sole payment of French interest could exceed 100 billion euros per year in the next few years… That is to say the main expenditure of the State in front of education, the army… But that’s not counting the debt service (that is to say, the repayment of the debt itself). Every day, several billion euros of debt are rolled up. Nevertheless, a problem of financing or confidence of the lenders would be enough to literally destroy the stability of the public finances of all the European countries. En this sense, the ECB takes the risk of overthrowing the pyramid that it has itself built…

The fact that key rates are entering a new era of increases is economically sound, but politically catastrophic… Maybe the ECB was she trying to play for time to earn precious months of low-cost credit?

Furthermore, we must also remember the historical loss of value of bonds (state and corporate debt). This last reached almost 20% according to Bloomberg. The bond market is the second largest market in the world after the real estate market. As a result, the loss in value of bonds is hurting many funds that provide savings, pensions and the investments of tomorrow… In this context, some assess the (theoretical) loss in value of the ECB’s balance sheet at nearly €1 trillion (loss in value of bonds held by the ECB)… This loss would materialize if the ECB were to reduce its balance sheet and liquidate some of its assets.

The problem of trade deficits and living standards

The figure for the French trade deficit appeared today at 2:45 a.m. The French commercial situation is becoming absolutely critical. In July, the French trade deficit amounted to -14.5 billion euros, well below forecasts (-13.4 Billions of Euro’s). For June, this deficit was 13.1 billion euros. In January 2022, this French trade deficit was -8 billion euros. Over one year, the French trade deficit is close to 130 billion euros… Unheard of in French history.

Indeed, it must be said that this deficit represents the equivalent of more than 5.1% of French income. That is to say that the French have lost the equivalent of more than 5% of their income over one year solely because of the trade deficit! In Germany, the trade balance remains extraordinarily weak (+5.4 billion euros in July, against +17.7 billion euros a year ago). This European situation worries the markets. It must be said that the structural outlook is not ideal and that the euro is under a dangerous weight.

In addition, the serious deterioration in the economic situation for the trade balance implies not only a fall in the standard of living, but also risks for the future of the euro. Between 2008 and 2021, the average per capita income in the euro zone fell from $42,355 to $42,307. In France, over the same period, the standard of living even fell by nearly 4.4%, dropping from $45,520 to $43,518. While the standard of living is declining in Europe, it is increasing significantly in the United States. EBetween 2008 and 2021, the average income in the United States increased by more than 42%! We had hoped during the Trente Glorieuses for Europe to catch up, but it is clear that Europe has lost itself. The gap between Europe and the growth observed in certain regions of the world is widening heavily…

In conclusion

In short, we have seen that the decisions of the ECB are of strategic importance. With inflation still on the rise and a historic drop in the euro, the ECB finally seems to be starting to tighten its policy. In addition, the ECB projects an increase in historical rates and that of its key rate close to 2% in 2024…

But this operation is all the more dangerous because it is necessary. The failure to fight inflation is dangerous for the economy in several respects. First of all, it would encourage the decline of the euro, but also the deterioration of the standard of living and stability between countries. Never has inflation been so far from the level of interest rates… The stability of savings and the economy is an absolute imperative.

However, the rise in rates and the fight against inflation are not without risk for States and certain companies… The heaviness of debts and deficits, as well as the weakness of macro-economic variables (trade balance, balance of payments, growth…) makes a policy of monetary tightening very risky. This impact will be lasting and will manifest itself in the coming years, which will certainly induce heavy political tensions. At the same time, the risk of a crisis in public finances adds to the credit risk and the risks associated with weak growth in the coming months. In this sense, some specialists believe that the euro could continue to fall over time despite supportive policies.

Thus, the ECB finds itself more in the costume of the shoemaker than the couturier. The difficulty of fighting inflation without threatening the long-term stability of the euro zone is an important dilemma. Today’s announcement by the ECB of a 75 basis point hike in the key rate confirms market expectations, which are down slightly.

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