ECB Monetary Policy Pressured by Two Strong Opposing Economic Forces

The European Central
Bank kept its benchmark interest rates unchanged, as widely expected and stuck
to its decision to end the stimulus program in the third quarter of this year
but did not provide any further details that disappointed markets, as many expected
a hawkish reaction in light of surging inflation that prompted a number of
major central banks to start tightening policies.

The ECB’s President Christine Lagarde
pointed to growing uncertainty on the war in Ukraine, as the main obstacle, but
said that the central bank will maintain optionality, gradualism and
flexibility in conducting its monetary policy.

The end of asset
purchases could come at any time in the third quarter but without any further
information about the timing, as well as no timeframe for when the central bank
would start to raise rates, adding that rate hike could occur weeks or even
months after the stimulus ends and when the ECB gets there.

Unexpectedly dovish
stance suggests that the European Central bank is diverging from its all major
peers, as the US Federal Reserve and The Bank of England already started to
tighten their policies after nearly three years, with the US central bank
leading on expectations for eight or more hikes in next two years.

The most recent action
in increasing the cost of borrowing, was seen from the central banks of New
Zealand, Canada and South Korea.

The policymakers were
split, as hawks, including governors of Germany, Austria, Netherlands and
Belgium, made the case for rate hikes, arguing that inflation could rise
further, with households and the economies overall being already strongly hit
by rising energy prices, draining
household savings and growing uncertainty.

On the other side,
doves supported their decision by the notion that most of the inflation is a
result of an external supply shock, therefore the price pressures will fade over
time.

Lagarde supported the
central bank’s decision to stay on hold, by the situation in Ukraine, as all 19
economies of the eurozone are heavily exposed to the conflict that further
damages the confidence and adds to persisting supply disruptions that started
during the coronavirus pandemic.

The bloc’s members are
also strongly concerned about the reverse impact of sanctions imposed on
Russia, as the newest plan to add Russian oil and natural gas to the list of
banned items imported from Russia, as the bloc is so far lacking unity on this
matter, with strong dissonant tones coming from Germany, the EU’s largest
economy, Hungary and Slovakia.

If all members agree on
imposing sanctions on energy from Russia that would further undermine the
already fragile bloc’s economy, not recovered from the pandemic and sent most
of the countries of the union into recession, a scenario that all want to
avoid.

Lagarde stressed that
the EU economy’s development will be strongly dependent on how the conflict
evolves that results in the central bank’s prolonged ‘sit and wait’ policy
which continues to damage the confidence and darkens the outlook, as economists
already lowered bets on a rate hike by the end of the year.

The ECB currently faces two opposing economic
forces as the recent surge in inflation, which rose to a record high at 7.5%,
collides with the central bank’s
purchases of nearly 5 trillion euros of public and private debts in the past
few years, aiming to revive inflation which was stubbornly low since 2015 until
recently.

Continuation of pumping
money into the economy, although the ECB signaled it will end purchases
sometime in the third quarter, will continue to fuel the inflation which is
already at the historical high and threaten of further undermining the economic
growth that would push the bloc’s economy into recession.

On the other side, the
European Central Bank fears that raising interest rates in a situation when the
economy has not recovered from a strong contraction during Covid pandemic,
could produce a negative effect.

Overall, the EU is in a
difficult situation, as five top German economic agencies sharply lowered their
forecasts for the GDP growth of the bloc’s largest economy which is expected to
reflect on the whole union’s economy, with a dramatic warning that the economy
would fall into recession as the EU would sanction itself by imposing sanctions
on Russian energy.