There was a time when central banks liked to surprise the markets when they moved interest rates. Now central banking is all about “forward guidance” and preparing the way, so we know the European Central Bank will increase interest rates next week. But the bank’s governing council is a house divided, struggling to demonstrate that it has any prospect of controlling inflation as the euro zone economy potentially heads for 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 Italian government debt as Mario Draghi’s coalition wobbles. The markets reckon that recession is coming in the euro zone – and it will come if gas supplies from Russia are cut off, though we don’t yet know if this will happen.
In the middle of this maelstrom sits the ECB, where president Christine Lagarde leads a clearly divided governing council whose members are at odds on what to do about rising inflation. It is under attack for being “behind the curve” as the Bank of England and US Federal Reserve Board are already raising interest rates. But while higher interest rates will cool economic growth and have some longer-term impact on inflation, they do nothing to stop the immediate pressure on prices, which is coming from higher costs for energy, other commodities including food, and messed up global supply chains.
Central banks are thus facing big credibility challenges in their drive to control inflation. For years after the financial crash, they failed to get inflation up to their target level of around 2 per cent, despite massive monetary expansion. Now they face the opposite problem – how to withdraw the massive stimulus to bring inflation down without adding to the economic upheaval.
Doing this as recession looms and in the midst of a cost-of-living crisis will be tricky, to say the least. In an era when big institutions fight to retain wider public trust, central banks face a mighty test. They need to persuade the public that they can bring down inflation, because public expectations are vital in shaping what happens. But people are more likely to be influenced by their gas bill, their supermarket shop and the cost of filling up the car. If they increase interest rates just as economies are tipping into recession, then they risk being blamed for imposing rising unemployment and economic pain. And in the current populist era, they will get hammered as part of the “establishment of elites” who don’t care about ordinary people.
Central banks will search for a middle road through this. But there simply may not be one. Having failed to persuade people that inflation was going to rise for years, central bankers are unlikely to be the ones persuading them that it will fall from its current stratospheric levels. If growth collapses but inflation stays high then we have the central bankers’ nightmare – stagflation and an ongoing policy dilemma.
As if all this is not enough, the ECB faces another job. It is to stop speculation hitting the euro zone government borrowing markets, pushing up the cost of borrowing for vulnerable countries – with Italy first in the firing line. With a high debt level and the need to accelerate growth, Italy is the most vulnerable country to market speculation. Now the threatened collapse of Mario Draghi’s Italian government has upped the ante. It is striking that the man who said in 2012, as ECB president, that the bank would do “whatever it takes” to save the euro is now at the centre of the latest drama.
If Draghi’s government collapses, then Italy’s economic programme, needed to draw down vital EU funds, will be in peril. And its cost of borrowing – which has already jumped to more than two percentage points above Germany in recent weeks – could spike further. The ECB has promised to come forward 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. The hardliners on the ECB board – led by the Netherlands, Germany and Austria – are in favour of higher government borrowing costs being allowed to impose economic discipline on countries and will insist on strict conditionality via budget promises for any special market support from the ECB. You can just imagine how this – with its echoes of the last financial crisis – would sell in Italy in the middle of what could be a general election campaign.
For Ireland, a European recession, as Paschal Donohoe warned this week, is a worrying prospect and so are the sky-high gas prices and supply threats that would cause it. The Irish economy emerged through Covid shutdowns in remarkably good shape and surged ahead last year. But consumers are now battered by higher prices and overseas markets are slowing. The first-quarter economic data suggests that growth in the domestic economy has already slowed and export markets are also likely to be hit in the second half of the year.
Higher interest rates will also have an impact on household and national finances, though Europe’s poor growth prospects may mean less dramatic ECB rises later this year than had been anticipated. A key goal for Ireland must be to stay out of the market crosshairs if euro zone tension builds.
After years of relative calm in the wake of the financial crisis, everyone is still trying to get to grips with the new era of instability. It is throwing up real short-term problems and putting longer-term issues, notably climate change, on the back-burner. In the midst of this, the ECB looks to face an impossible task at its meeting next week. It could be a messy autumn.