It’s supply chain issues, war and a weak currency – until this week the euro was at its lowest level in five years against a US dollar which has strengthened markedly in response to the the Fed’s sudden adoption of tighter monetary policies – which is causing inflation. rate.
Lagarde singled out “imported” inflation, describing it as a “tax on the terms of trade”. Over the past year, she said, the eurozone transferred 170 billion euros ($257 billion), or 1.3% of its GDP, to the rest of the world via the net cost ( after accounting for more competitive exports) higher imports. prices.
The ECB’s policy shift that has seen its balance sheet explode from around €1.5 trillion in 2007 to around €8.8 trillion today will add to the global monetary tightening that is already wreaking havoc on markets. of investment. The Fed’s balance sheet grew from less than US$1 trillion ($1.4 trillion) to around US$9 trillion over the same period.
The actions proposed by the ECB will however contribute to weakening a US dollar which was appreciating rapidly and not only against the euro.
This could bring some relief to emerging market economies and even China, which were experiencing capital outflows and higher borrowing costs and debt repayments on US dollar-denominated debt as the dollar strengthened. .
The dollar has appreciated about 8% against the basket of currencies of its major trading partners this year and has sparked talk of a new Plaza Accord (a 1985 agreement between the G-5 economies to force the then booming dollar value) before Lagarde’s blog.
The radical change in ECB policies, assuming it happens, is not without risk.
The pandemic has caused considerable damage to some European economies which had very fragile finances even before COVID hit. Over-indebted economies added even more debt even as their condition deteriorated.
The post-financial crisis underlines that the Eurozone nearly blew up was centered on Southern Europe (remember “Grexit” and “Quitaly”) and they will feel the brunt of rising interest rates more than Germany or France with their stronger economic fundamentals.
Greece has a debt to GDP ratio of around 185%. Italy’s is around 150%, with a budget deficit of around 10% of GDP. Portugal’s debt-to-GDP ratio is 122% and Spain’s almost 120%.
The potential for a new sovereign debt crisis in the eurozone is real.
Southern Europe, and Italy and Greece in particular, have been buoyed by negative interest rates and ECB bond purchases. The ECB absorbed almost all Italian debt issues.
The end of quantitative easing and higher rates, even if they remain at negligible levels, will put pressure on the economies of southern Europe and impose new pressures on the cohesion of the European project and on a bloc which nearly fractured in the aftermath of the financial crisis due to the disparate conditions of its individual economies.
If the ECB takes action on Lagarde’s comments, it will finally end the new monetary policy period.
The ECB’s negative rate – its key rate today is minus 0.5% – was designed to try to force European lenders to lend rather than pay to deposit their excess cash with the central bank and other financial institutions to accept more risk in pursuit of positive goals. Return.
The post-financial crisis underscores that the eurozone’s near-blowout was centered on southern Europe and they will feel the brunt of rising interest rates more than Germany or France with their fundamentals. stronger economies.
The ECB would claim that the policy has been successful, although it has reduced the already modest profitability of European banks, undermined the solvency of pension funds and produced perverse results by encouraging an influx of liquidity into negative yielding assets. as investors feared rates would turn more negative. territory. There were even “borrowing” companies that could borrow at negative coupons – they were paid to borrow!
It was not entirely unique to Europe. At their peak in 2020, there were nearly $19 trillion in corporate and government debt instruments with negative yields. Today there are hardly any left.
If the Fed and the ECB and others (like our Reserve Bank) can back out of the unconventional monetary policies that the two major central banks have pursued for most of the past 14 years without blowing up economies and markets in the process (or at least not completely melt the markets), it would be an important step in the progression of the financial crisis towards more normal historical parameters.
This “if,” however, looms large for Italy and other Southern European countries, for China and emerging market economies, and for investors in everything from equities to crypto assets, in particular. through bonds – just like a successful transition and the dramatic tightening of global financial conditions and higher cost of credit that would entail. It’s a brave and risky new world.
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