FRANKFURT — Mired in a two-front war against surging inflation and slowing growth, the European Central Bank may have to reassign its troops.
Just weeks before the central bank plans to raise rates for the first time in more than a decade to battle soaring prices, economists warn that a looming recession may force it change tack again
“Central banks are embarrassed by having gotten inflation wrong — I think most of us did — and now want show how committed they are,” tweeted EFG Bank economist Stefan Gerlach last week. “Two wrongs don’t make a right, and I fear this chest thumping may lead to recession.”
Burned by premature rate hikes in 2008 and 2011 in the midst of the financial and the sovereign debt crises, the ECB has been slow to react to inflationary pressures, putting it in a particularly difficult spot compared with its counterparts, he said.
The Bank of England has raised interest rates five times, while the Federal Reserve increased its rates three times, including a giant 75-basis-point move in June. The ECB’s rates, by contrast, have remained in negative territory and are set to rise by 25 basis points only later this month.
The Institute for International Finance, which has warned about a looming global recession, has been calling on the ECB to abort any tightening plans altogether since early June.
At the time, central bank staff projections still pointed to solid growth. They saw eurozone GDP expanding 2.8 percent this year and 2.1 percent in both 2023 and 2024 — projections that increasingly seem too optimistic. A fresh 17 percent jump in natural gas prices in Europe this week pushed recession fears to front and center in financial markets.
ECB Vice President Luis de Guindos acknowledged as much earlier this week. “The downside scenario in our June projections reflects this risk and implies a contraction of activity in 2023, following weaker but positive growth in 2022,” he noted.
Berenberg economist Holger Schmieding is among those who have adopted a more bearish outlook, and expects eurozone GDP to drop 0.8 percent next year.
“The ECB is well aware of the worsening risks,” he said. “However, policymakers still seem far away from regarding recession as the most likely outcome, as we do.”
That sinking feeling
There’s no denying that dark clouds are gathering over the horizon, with fears of a eurozone recession driving the euro exchange rate to a 20-year low against the dollar on Tuesday.
Activity in the manufacturing sector declined for the first time in two years in June, and a drop in orders across the region suggests the downturn will gain momentum in the coming months, the key PMI survey showed Tuesday. While the services sector has kept the economy growing for now, expansion there is beginning to slow as well.
Meanwhile, threats to the region’s energy supply could push the economy over the edge, economists warn. German Economy and Climate Minister Robert Habeck, for instance, warned last week that the region’s largest economy could face a complete shutoff of Russian gas by mid-July. Germany’s central bank has estimated that such a shock could dent the country’s GDP by 5 percentage points.
Despite these signs, Gerlach warns that central bankers “almost seem impervious to this risk,” as they remain all too eager to regain their inflation-fighting credentials.
To be sure, the ECB’s primary mandate is to ensure price stability, which implies that inflation considerations should trump growth concerns.
But if the region falls into recession, the risk of currently high and largely imported inflation feeding through the economy via higher wage demands would drop sharply — so inflation pressure should abate without a tightening of policy.
Still, nobody expects the central bank to heed the IIF’s call to abort interest rate hikes wholesale. Eurozone inflation is still red hot, hitting 8.6 percent in June and expected to rise further this summer, and the ECB has all but promised rate hikes for both July and September.
In fact, the risk of a policy mistake that would see the ECB tightening into a global slowdown and throwing the currency region into recession is real, Gerlach warns.
Short of that scenario, however, economists and investors are starting to scale back their expectations for the hiking cycle.
“If we are right with our calls for a eurozone recession, the ECB will have to revise its outlook substantially again in December,” Schmieding said. “Although inflation at that time will likely exceed the ECB’s current projections by a significant margin again due to even more elevated gas prices, the recession should lead to a faster and bigger fall in inflation thereafter.”
Under Schmieding’s forecast, the ECB won’t lift its refinancing rate over 1 percent and its deposit rate over 0.5 percent. The rates currently stand at zero and minus 0.5 percent, respectively.
The ECB’s Fabio Panetta, a leading dove, has sought to dampen expectations of a string of rate hikes, noting last Friday that the central bank had only committed to lift rates out of negative territory. Any further adjustment, he said, will depend on the evolution of the outlook for inflation and the economy.
Financial markets, meanwhile, have scaled back rate hike expectations quite considerably. At the end of June, they saw an increase of around 300 basis points through June 2023, but they have lowered that estimate to around 200 basis points this week.
Some economists, though, say such an increase is still too bold.
“Markets continue to price a substantial ECB hiking cycle,” IIF chief economist Robin Brooks said Tuesday. “That’ll never happen.”