Risks to the financial stability of the euro area are increasing, without exception: banks, governments and households are now in the crosshairs of increasingly gloomy economic prospects as inflation hits record levels. So writes the ECB in its Financial Stability Review, also signaling the potential dangers for public finances, with governments trying to cushion the impact of the energy crisis. “Citizens and businesses are already feeling the impact of rising inflation and the slowdown in the economy,” said ECB Vice-President Luis de Guindos. “Our assessment is that risks to financial stability have increased, while a technical recession in the euro area has become more likely.”
The mix of soaring prices and shrinking output created by Russia’s war in Ukraine is straining policy makers and investors alike. There ECB has started the cycle of rate hikes more aggressive than ever to prevent inflation from taking root, even when an economic downturn is looming. The hikes are set to continue, the central bank says, with risky assets remaining “sensitive to the uncertain path of inflation” and economic and monetary policy developments, the ECB says. “It is very difficult to have financial stability without price stability,” de Guindos told reporters in Frankfurt. Officials have expressed concern about the fallout from the tensions on the markets. “Changes in asset prices have reflected growing uncertainty about what will be required of monetary policy to moderate inflation in advanced economies.
Not for the first time, when positions are leveraged or when exposures are created through derivatives, the impacts of market shocks are often felt well beyond the investors directly affected.” Banks, meanwhile, may have to set aside more money for non-performing loans and bad loans next year. “Rising interest rates are weighing more heavily on fiscal positions than previously anticipated,” the central bank’s report reads. “A further deterioration in financial conditions could therefore change market sentiment towards some of the euro area sovereign issuers”. Separately, housing markets may be “at an inflection point” as rising financing costs reduce demand for new loans. Going forward, warns the ECB, a prolonged period of high inflation would pose a risk to the financial stability of the euro area as it could exacerbate the squeeze on household incomes, potentially threatening even middle- and high-income households. “Returning inflation to its medium-term objective therefore remains of paramount importance,” concludes the document.