ECB pursues flexibility as divisions deepen over Ukraine crisis


The war in Ukraine threatens to derail the eurozone’s recovery, drive consumer prices higher and reopen divisions at the European Central Bank over the future direction of monetary policy, putting officials in an uncomfortable position ahead of their meeting on Thursday.

Europe’s dependence on Russian energy means it is bound to suffer more than most regions from the economic fallout of the war in Ukraine, analysts said, leaving the ECB torn between fighting record inflation and cushioning the expected hit to growth.

The eurozone economy was facing “a huge stagflation shock risk” – the toxic mix of stagnant growth and high inflation, said Frederik Ducrozet, a strategist at Pictet Wealth Management. “Uncertainty has never been this high, so it makes absolutely no sense for the ECB to make any firm commitments to change anything.”

Only last month, the ECB governing council agreed it could speed up a “gradual normalization” of its ultra-loose monetary policy, setting the stage for it to end net purchases under its € 4.8tn bond-buying program and to raise interest rates by the end of the year.

But now investors are betting the central bank will put those plans on hold, opting to maintain as much flexibility as possible while it assesses the implications of the crisis for the 19 countries that share the euro.

“For policymakers what dominates here is the negative impact on growth,” said Katharine Neiss, chief European economist at PGIM Fixed Income. “The ECB needs to take control of the inflation narrative and clearly indicate that it is being driven by an external shock with negative consequences for growth – that is the dominant theme.”

Line chart of showing Inflation has soared well above the ECB target

ECB President Christine Lagarde has already signaled it could maintain a high level of monetary support for longer by promising last month “to take whatever action is needed” in response to the Ukraine crisis.

Philip Lane, the bank’s chief economist, went further last week, saying it should accept inflation surging above its 2 per cent target for longer when facing “an adverse supply shock” like the one caused by the conflict. The ECB could even consider “new policy instruments” to support European financial markets, he added.

However, some ECB governing council members are still convinced it needs to speed up the withdrawal of its stimulus in response to inflation that hit a new eurozone record of 5.8 per cent in February and is expected to rise as high as 7 per cent this year.

“We need to keep our sights trained on the normalization of our monetary policy,” Joachim Nagel, head of Germany’s central bank, said last week.

Other hawkish ECB officials say it is better to tackle high inflation now before the Ukraine crisis makes it even worse. They say Russia accounts for only 4 per cent of EU exports, limiting the direct impact of an economic blockade on the country.

Russia provides about 40 per cent of the EU’s natural gas and economists think the biggest risk is if it cuts off this supply. But hawkish officials say this is unlikely, pointing out that Russia continued to supply gas to Europe throughout the Cold War.

Stiffening the resolve of the hawks is the surge in prices for energy and other commodities. Oil hit a 14-year peak this week, with JPMorgan predicting it could rise another 50 per cent by year-end, while European gas hit a new record. Wheat and nickel have reached all-time highs.

Line chart of Dutch month ahead wholesale natural gas price (€ per megawatt hour) showing Gas prices have shot up in Europe

The fall in eurozone unemployment to record a low of 6.8 per cent in January makes it more likely that workers will soon push for much higher wages, which the hawks fear will make inflation harder to bring back down. The euro’s fall close to a five-year low against the dollar will add further inflationary pressure by increasing the cost of imports.

“It is obvious that inflation will stay with us, so we have to do something,” one hawk on the ECB governing council told the Financial Times. “We can’t just say we will wait and see.”

The ECB will publish new forecasts on Thursday, widely expected to project lower growth and higher inflation. But some economists, such as Reinhard Cluse at UBS, expect it to keep its inflation forecast just below its 2 per cent target for the next two years – allowing it to say that a key condition to raise interest rates remains unfulfilled.

The Bruegel think-tank estimated that if Russian gas supplies to Europe are cut off it would leave the region unable to refill storage tanks before the next winter and force it to reduce energy usage by 10-15 per cent via painful rationing. The EU is due to unveil a plan to cut Russian gas imports by two-thirds within a year, by increasing supplies from other producers and boosting energy efficiency.

But Goldman Sachs calculated a total shutdown of Russian gas supplies to Europe could cut eurozone gross domestic product by 2.8 percentage points. PGIM estimated the impact could be as much as 5 percentage points of GDP, raising the prospect of a third recession in two years.

Elga Bartsch, head of macro research at the BlackRock Investment Institute, said: “This crisis is another supply shock that reinforces our view that central banks will choose to live with high inflation.”

Economists think the ECB is likely to seek a compromise between hawks and doves by making subtle but symbolically important changes to how it describes its future intentions.

One option is to remove the word “shortly” from the ECB’s statement that it will end net bond purchases “shortly before” it raises interest rates, which would give it more leeway to stop buying bonds without signaling a rate rise is imminent.

A second could be to drop a reference to a potential rate cut from its guidance, making it clearer that the next move on rates will be upwards.

Even so, the ECB’s divisions over how to respond to the pressures caused by the Ukraine crisis mean any such compromise could be hard to find.



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