“Lagarde will raise the cost of money by 25 basis points, but risks losing part of her credibility.” Silvain Broyer, European chief economist at S&P Global Ratings, believes the European Central Bank (ECB) will wait even before giving a clear signal to the markets. And that it will try to hold off the front of governors, such as Germany, Austria, Finland and the Baltics, who would like to raise interest rates by 50 basis points tomorrow. But precisely because the Italian political crisis is worrying, Lagarde could take time. An element that would, however, exacerbate the already present divisions of the board.
What are the expectations?
«First of all, we expect a decision on rates and indications on the Transmission protection mechanism (Tpm). As regards rates, we do not expect the ECB to deviate from the indications transmitted at the last meeting. We therefore expect a rise of 25 basis points for this month and a clear indication that the cycle will continue with a rise of 50 points in September ».
Why not more?
«For two reasons: the ECB has never started the normalization cycle with increases of more than 25 basis points. They always start slowly. The second reason is that if the ECB goes beyond what has already been promised it would be seen as a sign of panic ».
On the anti-fragmentation shield?
“We expect indications but probably not a final decision, or at least we will not know all the technical aspects of the mechanism. We believe that the ECB will need more time to define the instrument ”.
What to say about the possible intervention fork on spreads?
“I think it would be a big mistake. It is not a good idea to act on spreads motivated by several factors, not just monetary policy. Having quantifiable targets would mean controlling the yield curve of 18 markets. It would be technically very difficult and would raise numerous doubts from a regulatory point of view ”.
Lagarde has often said that the ECB is a “journey” towards the normalization of monetary policy. What possible errors on the horizon?
“It depends on what is meant by normalization. Interest rates or the ECB balance sheet? We know that the Federal Reserve and the Bank of England have already intervened on both fronts. The ECB, at the moment, focuses only on interest rates and their rise – hopefully, at the level of the European economy – probably up to the neutral level of about 1.5%. In the case of rate normalization, the ECB may want to avoid raising rates too quickly ”.
Alternatively?
“The real issue is whether the ECB would retrace its steps with regard to the normalization of its balance sheet, like the Fed, and if it interrupted the Tltro (the long-term refinancing operations, ed), or if it will start a new block (of operations, ed). As regards the normalization of rates, there are not many mistakes that Frankfurt can make. But what it could do in normalizing its balance sheet could have more lasting consequences, and more adverse consequences for investors in general ”.
Do we have a problem of inflation and real wages?
“From a consumer point of view, there is certainly a problem of rising prices, as they can find almost daily. But from the point of view of central banks, which have to intervene on inflation in the medium term, the main negative surprise is linked to energy prices, linked to the war and to the prospects for Russian gas. Core inflation is already slightly down. And market expectations for inflation are down sharply from 2.6% to 2% for one-year inflation. So there are no signs that expectations of uncontrolled inflation are in line with core inflation. So the problems for the ECB only concern what could happen with energy prices ”.
Of course, however, many energy components have been passing directly to consumers for months.
“Yes, already last year we saw a faster pass-through than usual. But Core inflation is not rising as fast, at least not as fast as it is in the US. Core inflation is 3.7% in the Eurozone ”.
Then?
“So the ECB is not facing the same critical issues as the Fed. Inflation is less demand-driven in the Eurozone than in the United States. Wages in the Eurozone are also not heating up. We are seeing some recovery in wage negotiations at the Eurozone level, but much of this recovery has been achieved thanks to special compensation for Covid in Germany, and the underlying wage trend in the Eurozone is below current levels. So, as mentioned, the ECB is even less in a hurry to raise rates and normalize monetary policy than the Fed ”.
Let’s talk for a moment about Italy. Why are BTPs always under pressure?
“First of all, the widening of the spreads we have seen in recent months is not excessive. It is quite common for spreads on European government bonds to widen during bear market times. In my opinion, the fragmentation, if you will, was perhaps more on Bunds than on BTPs, considering that German yields increased as much as U.S. Treasury yields in the first half of June, despite very different outlooks in terms of the economy. and monetary policy – this was the anomaly, but the widening of the spreads between the BTP and the Bund is part of the statistical norm for a bear market ”.
What direct consequence?
“Now the bond market is cooling down a bit. BTPs are now 220 basis points above the Bund, despite the latest political events. Not much, I would say. Then there is a question of liquidity. The ECB has bought over 700 billion euros of Italian bonds, let’s not forget ”.
And therefore more pronounced fluctuations. The Italian situation is particular. What challenges for the next time?
“We expect the Italian economy to experience a sharp slowdown in growth next year: GDP has increased by about 2.8% this year, but will only grow by 1.9% next year.”
This is the scenario without a Russian gas cut, right?
“Yup. Imports of Russian gas into Europe are already very low, but gas stocks have risen consistently so far ”.
The challenges, we said.
“They are twofold, in my view: on the one hand, it’s about restoring consumer confidence. The second challenge has not changed compared to the past: it is a question of investing public funds, and in particular the Next Generation EU Fund, in a strategic way, so as to increase the productivity of the country “.
Last question: is there no credibility risk for the ECB in such a delicate phase? Raise the front of those who want more incisive actions.
“I think it is normal that there are discussions of this kind among the members of the Governing Council of the ECB, primarily because there are large gaps between the different member states in terms of inflation. These gaps are due to fiscal policy, ie the way in which Member States protect consumers from increases in energy prices. For example, retail gas prices for consumers in the Baltic countries increased by 300%, while in Germany they rose by less than 40% and remained unchanged in Malta. This is a national problem, which the ECB cannot deal with ”.
What challenge for Lagarde?
“Now, the challenge for the ECB is that the kind of price dynamics we have and the inflation outlook we might have are largely independent of the central bank’s actions. So, perhaps we will find ourselves in a situation where the ECB will raise rates and inflation will not go down. Or, conversely, the ECB will raise rates less than other central banks and inflation will drop sharply next year – we don’t know. This is the real challenge for central banks. This is where their credibility is not at risk, but at least at stake ”.