The inflation conundrum for ECB

The ECB seems to be facing the conundrum as inflation continues to soar. Photo: Ms. Christine Lagarde, ECB President

>> What to expect from ECB’s new mechanism?

Alternatively, it can hang back with rate hikes, but this risks much higher inflation, much higher yields and very possibly the same debt crisis that could arise from the first scenario. In short, the ECB is walking on a tightrope and it might ultimately have to decide which side it wants to fall off.

Annual inflation in the euro zone has now climbed to over 8%. Importantly, the ECB’s worst case scenario of significant ‘second round’ effects is starting to play out. Of course, all the headlines relate to the 39%-plus annual surge in energy prices or the 7.5% annual rise in food/alcohol/tobacco prices, but what’s of more significance is that core inflation is moving sharply higher, up to 3.8%, and clearly showing signs that firms are being forced to pass on cost increases caused by high commodity prices.

The fig leaf that the ECB still clings to is that wages are not rising sharply but, even here, the evidence is starting to change. In Germany, for instance, agreed earnings rose an annual 4% in Q1 according to data released on Monday. That’s up sharply from 1.1% in Q4 and, in Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, the first indication that wage awards will rise significantly. He sees this trend repeated around the euro zone, leaving the ECB exposed to a wage and price spiral.

Unsurprisingly, there is much debate about the ECB’s rate response or, should we say, the lack of response given that the deposit rate is still negative and the bank is still currently buying bonds. These net purchases will likely end in early July and the ECB will lift rates soon after – at the July meeting. The surge in inflation and signs that inflation expectations are de-anchoring from the 2% target would seem to cry out for a more determined response.

So far, ECB members have talked about a 25-bps hike in July and a similar sized move at the following meeting in September. Is this enough? It does not seem so. Should the ECB underwhelm with its monetary response it runs the risk of seeing inflation rise much further, yields soar and fragmentation threats rise.

Unlike other central banks, the ECB has to consider how different bond markets in the euro zone will cope with tighter policy and surging inflation. If bond markets move in wildly different directions, with high inflation bond markets plunging in value, the ECB could have a situation on its hands that’s not unlike the debilitating debt crisis of 2010/12 when Greece very nearly left the Union.

Perhaps fortunately, the countries with the really high inflation now such as Estonia (20.1%), Lithuania (18.5%) and Latvia (16.4%) are also the ones with relatively low debt burdens. But these burdens are rising fast and it is certainly not beyond the realms of possibility that the market starts to really attack these high-inflation countries, creating a trickle-down effect as the bond vigilantes turn to the high-debt countries that still have very high inflation even if it is not at the top of the EMU table.

>> How will the ECB deal with the risk of stagflation?

One example is Greece with its debt load of nearly 200% of GDP and an inflation rate of 10.7%. It is just this sort of threat that’s made the ECB think about a new tool to tackle any fragmentation risk. The ECB could, of course, try to stamp down on the risk of such fragmentation by driving policy rates up quickly and aggressively to head off the increased inflation threat. But such is the precarious state of the euro zone economy that this would risk a deep recession and, as a consequence, equally significant risks of a debt crisis.

In short, the ECB is somewhere between a rock and a hard place and the chances of it – and euro zone bond markets – escaping unscathed seem pretty slim. “While we think that most of this will fall on the euro zone bond market rather than the euro currency, we still think it is wise to maintain a wide berth from the single currency as the parity risk against the dollar remains high”, Mr. Steve Barrow said.