ECB financial policy: a critical review

ECB financial policy: a critical review

  • Euro area annual inflation: 10.7% in October 2022
  • Monetary policy aims to prevent wage-price spiral
  • Interest rates at 1.5%, Klaas Knot: “We are not even at half-time yet”
  • ECB total of €5 trillion debt, quantitative tightening (QT) will probably start in 2023
  • Greece’s Debt/GDP ratio over 182%. Temporarily suspended EU limit of 60% to return in 2024.
  • $1 trillion burden looms for borrowers refinancing debt

As record inflation is hitting Europe, the European Central Bank (ECB) has been conducting aggressive monetary policy to bring inflation down to a steady level of 2%. Euro-area inflation surged to an all-time high of 10.7% in October 2022, a substantial deviation from the ECB’s 2% inflation target rate. At times when inflation is persistently high, the ECB has the ability to exercise contractionary monetary policy. Contractionary monetary policy aims at lowering inflation by increasing short-term interest rates, thereby limiting the amount of active money circulating in the economy. When interest rates are high, individuals and corporations are confronted with high costs of borrowing. Individuals are likely to spend less and corporations are expected to invest less, which will lead to less liquidity in the markets and a decrease in prices. At the same time, individuals and corporations are incentivized to save money due to the higher interest rates.

Inflation causes

The inflation that is afflicting Europe and large parts of the world is a result of a variety of factors.

  1. Primarily high food and energy prices as a result of the war in Ukraine. The supply of these goods is scarce while demand remains high, driving up the prices.
  2. Quantitative easing by the ECB in the form of special bond buying programs (PEPP), adding up to over €1.85 trillion in 2020 alone, severely increased the amount of money circulating in the European economies1
  3. Supply chain problems due to metal and chip shortages, high energy prices, and labor shortages are affecting companies’ abilities to meet the demand for a large variety of goods.

In order to bring down inflation, the ECB has raised interest rates by 0.5% in July 2022, and by another 0.75% in September and October 2022 bringing the current rate on depository facilities to a total of 1.5%. With a policy meeting planned in December, Dutch central bank chief Klaas Knot has stated that he favors an additional rate hike of 50 or 75 basis points stating that “We are not even at half-time yet”.

Efficiency of current monetary policy

While raising interest rates is generally a good way to battle inflation, the effectiveness of the rate hikes is uncertain as of yet. As increasing interest rates will not lower the prices of energy, food, or metals for production processes, the effect of the policy remains unclear. High-interest rates do however have a signaling function. When the general public expects that high inflation will be persistent for a long period of time, this may cause a wage-price spiral where workers will demand higher wages to compensate for the higher costs of living and employers will subsequently raise their prices. By increasing interest rates, the ECB tries to signal to the general public that it is trying to bring inflation back to a steady level of 2%, thereby trying to avoid the previously mentioned wage-price spiral.

On top of the interest rate hikes, the ECB is planning to reduce its enormous pile of €5 trillion debt by means of quantitative tightening policy in 2023. Quantitative tightening, also called balance sheet normalization, refers to the process of a central bank shrinking its monetary reserves by either selling government bonds or letting them mature and removing them from their cash balance. This removes money, and liquidity, from the financial markets.

Risks of the ECB’s policy

The main risk of the ECB’s monetary policy is that the slowing in demand as a result of the interest rate hikes will cause a recession. A recession, a fall in GDP in two successive quarters, will most likely result in higher unemployment, lower wages, and more general long-term economic effects. Another risk that could face the EU is the high debt of southern European countries. As borrowing becomes increasingly expensive, countries like Greece, which has a debt level of 182.1% of its GDP as of June 2022, could get into trouble. The EU law that dictates that European governments are supposed to keep public debt below 60% of Gross Domestic Product (GDP) was temporarily suspended during the pandemic but is due to return in 2024. With high borrowing costs and a potentially slowing economy due to the looming recession, Greece may face serious difficulties in paying back its loans. Greece, but also other, mainly southern, European countries that have accumulated large sums of debt, will be faced with high refinancing costs on their loans. Bloomberg found, using their index tracking $65 trillion in corporate and government debt, that due to the high-interest rates refinancing costs of the bonds in their index will add up to $1.01 trillion. This kind of high refinancing costs can put countries at serious default risk if the EU decides to enforce the 60% public debt cap that is now temporarily suspended. Greece will have to start paying higher interest on refinancing loans and simultaneously try to decrease its debt balance which is complicated by stagnating economic growth. Defaults happen when governments are not able to meet debt payments and can cause governments to lose creditworthiness, making it very difficult for them to raise debt in the future. In some cases, it could cause investors to lose (a part) of their investment, although this is very rare when regarding defaults of government bonds. In December the European Commission is set to discuss possibilities for countries to reduce their government debt using individual planning, rather than a uniform policy so that countries in trouble can reform their economy without crippling it. The discussion has long been feared, and fierce opposition from northern European countries like Germany is expected, as the credibility of policy lies in the uniformity of implementation according to German minister of Finance Christian Lindner.

As the stability of financial markets going into 2023 still remains unclear, the ECB’s policy poses several risks for the economy. A so-called ‘hard landing’ seems near unavoidable with record high inflation on the one hand and record high government debt on the other hand. The ECB will face a tough job trying to steer the markets away from a recession while decreasing inflation and avoiding government bond defaults.

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