ECB is on back foot and for once it's down to Germany
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[August 10, 2023] By
Francesco Canepa
FRANKFURT (Reuters) - The European Central Bank is on the back foot
again and this time the bad news doesn't come from Greece, Italy or any
of the usual suspects in the bloc's poorer south.
The club's biggest member and supposed powerhouse, Germany, has been hit
by a toxic mix of weak trading with key partner China, a slump in its
large manufacturing and construction sectors and even some existential
questions about a business model predicated on cheap fuel from Russia.
Trouble in Germany is hobbling growth in the euro zone as a whole and
threatening to push it into a recession, rather than the "soft landing"
of moderate growth and inflation that the ECB had penciled in and the
United States is still hopeful of achieving.
This is forcing a change of tune at the ECB -- from ruling out a pause
in its steepest and longest streak of interest rate hikes to openly
talking about one as soon as next month.
And the market thinks the central bank may even have to undo some of
those increases sooner rather than later, just like it did at the time
of its last tightening cycle in 2011 when debt crises in Greece,
Portugal, Ireland, Spain and Cyprus were accompanied by a broader
recession.
"There are some similarities between the 2011 circumstances and now,"
Richard Portes, a professor of economics at the London Business School,
said. "There was a major supply shock and inflation was clearly going to
be very short lived."
SICK MAN OF EUROPE - AGAIN
Unlike then, Germany rather than the south of Europe is at the epicenter
of the problem, bringing many commentators to dust off the "sick man of
Europe" moniker last used to refer to that country in the early years of
the new century.
It's not without irony that the expression should have been coined by
Emperor Nicholas I of Russia to describe the Ottoman Empire in the 19th
century.
Some of Germany's present misfortunes also originate in Russia, on which
Berlin had relied for a third of its energy supply until the invasion of
Ukraine jeopardized those cheap imports.
Others run deeper and are home brewed, relating to its over-reliance on
exports, lack of investment and shortage of labor.
"If the government does not take decisive action, Germany is likely to
remain at the bottom of the growth table in the euro area," said Ralph
Solveen, an economist at Commerzbank.
CAREFUL WHAT YOU WISH FOR
But at least some of Germany's troubles can be traced back to tighter
monetary policy.
The central bank has consciously dampened economic activity via higher
rates in an attempt to bring inflation, which at one point last year was
in double digits, to its 2% target.
Higher borrowing costs hurt manufacturers particularly hard because they
depend on investment and no euro zone country has a larger industrial
sector than Germany.
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The logo of the European Central Bank (ECB)
is pictured outside its headquarters in Frankfurt, Germany, April
26, 2018. REUTERS/Kai Pfaffenbach//File Photo
"To loosen monetary policy because Germany is in a difficult
position would be unwise but to tighten it would add macro pressure
to the micro-level pressures that beset the economy," Portes added.
This puts the ECB in a situation where it must contemplate wrapping
up its tightening cycle before witnessing the sustained drop in core
inflation it said it wanted to see.
Making such an explicit link between underlying inflation and the
need for continued rate hikes may prove awkward for the ECB, which
is now trying to shift the emphasis from raising borrowing costs to
simply keeping them high.
"They've made a mistake in accentuating underlying inflation too
much," said Carsten Brzeski, global head of macro for ING Research,
said. "The risk is that they have already gone too far."
For Ricardo Reis, a professor at the London School of Economics, the
ECB needed to start looking at the expected path of inflation "12 or
18 months from now" -- as it traditionally did -- rather than
current readings.
HIGHER FOR LONGER
The first sign of a change in the narrative started at the ECB's
last meeting two weeks ago and caught markets by surprise.
After declaring in June the ECB was "not even thinking about
pausing" its rate hikes, Lagarde changed tack in her latest press
conference, going as far as saying she didn't think the central bank
had more ground to cover "at this point in time".
Days later -- and after data showed inflation excluding energy,
food, alcohol and tobacco was stuck at 5.5% -- the ECB chose to
emphasize that most other measures of underlying prices had shown
signs of easing.
And ECB board member Fabio Panetta then made the case for
"persistence" in keeping rates high rather than raising them
further.
All this set the stage for a possible pause in rate hikes in
September, likely coupled with an option to come back for more if
needed and a pledge to keep borrowing costs elevated for a while.
But markets even doubt the high-for-longer scenario, with
substantial rate cuts priced in for the second half of next year.
"We continue to expect the ECB to pivot significantly over the next
few months, with no further hikes this year and March kicking off a
series of rate cuts," economists ABN-AMRO said in a note to clients.
(Reporting By Francesco Canepa; editing by Mark John and Christina
Fincher)
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