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ECB to stick to its guns despite Fed's hawkish turn

Portrait photo of Ashutosh Pandey wearing a blue collared shirt and a navy-blue blazer
Ashutosh Pandey
January 27, 2022

As the US central bank gears up to wean the economy off oxygen support, its peer across the Pond may be in no rush to get the eurozone out of the intensive care unit, says DW's Ashutosh Pandey.

The European Central Bank (ECB) headquarters in Frankfurt
The ECB will likely persist with its ultra-loose monetary policyImage: Wolfgang Rattay/REUTERS

The US Federal Reserve is all but certain to start raising interest rates as early as March, tightening its ultra-accommodative monetary policy that has been instrumental in the world's largest economy for surviving the worst shock in decades.

The central bank on Wednesday signaled that it would start winding up its massive pandemic support "soon" — including by reducing the size of its balance sheet that has swollen to nearly $8.9 trillion (€7.9 trillion) thanks to all the bond purchases it has made during the pandemic. The aim has been tocombat inflation which hit its fastest pace since 1982 last year.

The Fed's aggressive pivot, which has driven up borrowing costs in the eurozone, is prompting investors to ramp up bets that the European Central Bank will follow the Fed's lead and start hiking interest rates later this year, earlier than it has projected.

Such investors may be left disappointed.

ECB to stick to its guns

The ECB is unlikely to take cues from the US central bank. It would persist with its ultraloose monetary policy and ensure interest rates stay in negative territory until 2023. And as its president, Christine Lagarde, has said, it has "every reason" not to act as quickly as the Fed despite inflation in the bloc soaring to a record 5% in December, well past the ECB's 2% target.

The eurozone and the US economies are at different stages of recovery. While the US economy has already reached its pre-pandemic level, propped up by a much larger dose of stimulus, fewer COVID restrictions and faster vaccinations initially, the output in the eurozone is still to get there.

On the contrary, Germany, Europe's economic powerhouse, is seeing its recovery falter and is now staring into its second recession of the pandemic after its economy shrank in the last quarter, hurt by the rise of the omicron variant and persistent supply disruptions.

The bloc's recovery path is replete with risks, including the emergence of deadlier coronavirus variants and China's zero-COVID policy, which could increase supply chain bottlenecks. Then there is the specter of a war between Russia and Ukraine. Russia is the European Union's fifth-biggest trade partner and its biggest energy supplier, which leaves the already gas-starved EU in a much more precarious position than the US.

DW business editor Ashutosh Pandey
DW business editor Ashutosh PandeyImage: DW

Transitory inflation 

The ECB has stuck to its "inflation-is-transitory" argument even as the Fed retired the T-word months back. It argues that much of the inflation has been fueled by temporary factors such as shortages of containers and semiconductors, higher energy prices and lopsided demand and prices would come down once the economic anomalies caused by the pandemic subside. There are already enough signs which suggest that inflation in the eurozone may have peaked.

While many investors may feel that the ECB is not doing enough to tame inflation and risks falling behind the curve, the central bank is only being prudent by sticking to its dovish policy given that monetary policy tightening has a much swifter impact on the economy than policy easing.

A premature tightening to tackle inflation that is temporarily elevated would hurt the bloc's fragile recovery, and even if the bank reverses its course to control the ensuing damage, the easing would hardly be as effective in such a low-interest rate environment.

Benign wage inflation

Giving the ECB some breathing space is the bloc's job market, which so far has been an insignificant player in driving up prices.

The wage growth in the eurozone remains subdued. It's different in the US, which is on the verge of reaching maximum employment. Labor shortages in the country have pushed up wages, raising fears of a wage-price spiral.

A rise in wages is not only supporting higher spending but is also prompting firms to raise the prices of their goods and services as they look to guard their profit margins.

It's also worth noting that the current record inflation is expected to put much lesser pressure on negotiated wages in the eurozone than previous instances of inflation, as pointed out by Jessica Hinds from Capital Economics. That's because the number of collective agreements that include inflation clauses are far fewer today and those which do typically exclude energy prices.

While the ECB can afford to keep the money taps wide open for now, it should proactively seek to ensure that the Fed's hawkish turn doesn't cause a sharper rise in bond yields or borrowing costs, robbing the region of much-needed liquidity.

Edited by: Hardy Graupner

Portrait photo of Ashutosh Pandey wearing a blue collared shirt and a navy-blue blazer
Ashutosh Pandey Business editor with a focus on international trade, financial markets and the energy sector.@ashutoshpande85