How the ECB should start normalizing monetary policy


The war in Ukraine has left Europe facing both greater supply chain disruptions and rising commodity prices, problems exacerbated by the region’s dependence on the EU. Russian energy. Against this backdrop, the European Central Bank must find a way to hedge against a prolonged inflationary shock and economic downturn, while reducing support for financial markets amid heightened turmoil in global bond and commodity markets.

Rather than a pre-determined path of political “normalization”, ECB President Christine Lagarde and her fellow policymakers need a new playbook for navigating the period of volatility in growth, inflation and markets ahead of us.

The pandemic has revealed the complex and fragile nature of supply chains. Now mounting sanctions on Russia mean the continent has no choice but to find new trade suppliers and restructure delivery routes in key industries, from energy to metals and fertilizers, while reinforcing the immediate shock of business interruptions and the drop in consumer confidence due to soaring prices. , gas and consumer goods prices. These are matters far beyond what governments or the central bank can control.

Moreover, the euro zone is facing a structural demand shock. An increase in the costs of raw materials – not just gas but also agricultural raw materials and “green energy” metals, for which Russia is also a key supplier – means a permanent decrease in what businesses and households can spend on other things, depressing future investment and job creation. The ECB estimates that the de facto tax resulting from rising energy costs reduced consumer incomes and business profits by 150 billion euros ($163.7 billion) in the last quarter of 2021 compared to the previous year. The final tally will only rise as the war in Ukraine disrupts commodity markets, increasing the risk of a recession next year.

The result is a record inflation rate of 7.5% in the eurozone, well above the ECB’s 2% target. Inflation rates are high globally, reflecting bottlenecks in supply chains and underinvestment in key industries, but demand conditions in the Eurozone differ. For example, its labor market has not seen workers quitting their jobs during shutdowns and not returning to the degree seen in the US, or the skills drain the UK has experienced due to Brexit. As a result, wage growth has so far remained largely within the ECB’s comfort zone.

The truth is that the ECB has no good options to temper inflation. With energy prices up 40% from a year ago and growth well ahead of eurozone demand, the only way to bring inflation back to target outside the region finding a new, cheap energy source outside of Russia means destroying demand. This means raising interest rates sharply even as supply disruptions force businesses to cut production and erode consumers’ purchasing power. Not only will rate hikes fail to protect businesses and consumers from soaring energy costs, but higher borrowing costs will make it more expensive for governments to avoid a recession, especially for larger ones. mainland debtors such as Italy and Spain.

Moreover, the unwinding of the ECB’s asset purchases could raise the yields on sovereign bonds of highly indebted countries in the South relative to those in the fiscally conservative North, further raising companies’ costs of capital and slowing economic growth. much of the continent even before politics. rates have increased. For an economy that has relied on the ECB’s buying of government bonds to keep market frictions at bay following the region’s sovereign debt crisis, the end of quantitative easing will mean a painful adjustment. This is particularly the case for Italy, the continent’s biggest borrower, whose 2,700 billion euros of debt, or 150% of gross domestic product, had an average cost of 6% before the ECB launched its Pandemic Emergency Purchase Program in 2020, well above projected future nominal GDP growth.

Rather than sticking to a predetermined path of monetary policy normalization, the best course of action for the ECB will be to maintain the flexibility needed to respond to an evolving trade-off between growth and inflation risks in markets more volatile. In other words, the ECB will have to learn and act as conditions change. This requires a phased approach to how the central bank prepares to emerge from its pandemic-era toolkit of large asset purchases and negative interest rates. Policymakers need to be nimble in how they adjust policy rate orientations in response to faster inflation, distinguishing between demand- and wage-driven inflation and an external supply shock on incomes real and growth.

Flexibility will also be key in terms of how the central bank ends quantitative easing. This may force the ECB to intervene in government bond markets through direct interventions to avoid excessive volatility in borrowing costs and protect lenders’ funding conditions even when liquidity is withdrawn. In times of war and extraordinary uncertainty surrounding growth and inflation, perhaps the greatest power that monetary policy can wield is to ensure liquid, calm, and well-functioning public and private investment markets.

More writers at Bloomberg Opinion:

• Zero is a good destination for ECB rates: Gilbert and Ashworth

• Joint ECB and BOE warning on excessive leverage: Enria and Woods

• Market moves heighten risk of ECB policy error: Mark Gilbert

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Lena Komileva is Managing Partner and Chief Economist at G+ Economics, an international market research and business intelligence consultancy firm based in London.

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