The European Central Bank, between inflation and fragmentation

The European Central Bank, between inflation and fragmentation

The European Central Bank (ECB) will respect the sequence promised by its president, Christine Lagarde: it will first put an end to its asset purchases before raising its rates.

This is the conclusion of the meeting of the Board of Governors held on June 9 in Amsterdam. The central bank’s stubbornness in not deviating from the line drawn many months ago now can be annoying: with total inflation above 8% and underlying inflation (excluding food and energy) close to 4%, leaving the rate of its marginal deposit facility at -0.5% is increasingly difficult to justify. Whether it raises its rate in June or July, however, will make no difference either in terms of activity or in terms of inflation: the bond markets have been anticipating for several weeks a 125 to 150 basis point rise in rates by by the end of the year, financial conditions had in fact already tightened significantly.

Purchasing power reduced by 5%

The ECB’s situation today is far from simple. It now faces high inflation, but it also knows that growth is fragile. Soaring energy and food prices weigh heavily on the purchasing power and consumption of the poorest households: only the wealthiest can hope to cushion the erosion of their real income by drawing on their savings , that in particular accumulated during the pandemic.

If we assume, to fix the ideas, the distribution of income in the euro zone similar to that of France – the share of half of the households which earn the least is 30% – and the excess savings concentrated in the hands of those who earn the most, real consumption will not be able to return to its level of the end of 2019 until… the end of 2023. Of course, governments have taken measures to cushion the effects of price increases, but with purchasing power cut by 5% by inflation, the consumption of those who earn the least is likely to weaken dangerously over the next few months.

Without more targeted fiscal support for the most vulnerable households, growth risks stifling and the central bank’s position will become even more delicate. To prevent the euro zone from having to face turbulence in the coming months, a distribution of tasks between budgetary and monetary policies is necessary: ​​governments must prevent growth from weakening too much; the ECB must succeed in convincing the markets that it will not let inflation get out of control.

In addition to the credibility test faced by most central banks today, there is another, specific to the ECB. If inflation continues to surprise on the upside, the central bank must be able to move faster – by raising its rates not by 25 basis points but by 50, or by accelerating the pace – without the tightening of its policy increasing the ” financial fragmentation” between countries of the euro zone: the interest rates at which the most indebted States, those of Italy in particular, borrow must not be stretched unduly. This is where the success of the ECB’s “exit strategy” depends. The Governor of the Banque de France, François Villeroy de Galhau, has just reminded us: ” preventing fragmentation is part of the success of standardization “.

Which instruments to prevent fragmentation?

Skillful communication and verbal interventions implying that the central bank will not let a widening of spreads sovereigns compromising the “normal” transmission of its policy could, for a time, suffice. The risk is of course that the markets “test” the determination of the ECB. Drawing the outlines of the instruments she might use is important.

A few “main” principles must be observed: purchases of securities must in particular not contravene the prohibition on monetary financing (the ECB cannot undertake to intervene in all circumstances to prevent spreads sovereign) and they must remain “proportionate”. These principles are vague enough for the central bank to design a securities purchase program that satisfies them.

However, it is not certain that a new “anti-fragmentation” tool can emerge without reference to any conditionality. This negotiation of technical “details” is likely to be more difficult than the agreement which seems to have been reached on the need to preserve a homogeneous transmission of monetary policy. For the central bank, convincing the markets that it will not let the spreads to deviate “too much” without reacting is however urgent…


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