The euro in crisis, the week of truth for the European Central Bank and interest rates

Inflation in the eurozone at more than eight percent, the exchange rate of the euro at the level of the dollar and a government crisis in Italy: In this context, the Council of the European Central Bank (ECB) will meet this Thursday (21.07) to decide on the direction further monetary policy. At the Council’s last meeting in June, ECB President Christine Lagarde announced the turnaround in interest rates, which would be the first in eleven years. Base interest rates are first expected to rise by 25 basis points and then possibly by 50 basis points in September. In this way, the time of negative interest rates would end. But many banks are already reacting. In Germany alone, nearly 50 financial institutions have completely removed negative interest rates on their customers’ deposits, and more are likely to follow in the coming weeks.

The ECB comes late

But how soon the ECB will raise interest rates is the interesting question. “The ECB is too late,” says Gertrud Traud, chief economist of Landesbank Hessen-Thüringen, Helaba. Given the historically high inflation rate of 8.6 percent in the eurozone, she calls the situation “uncertain”: “Central banks all over the world have raised interest rates, now the ECB must show that it takes its job seriously and fights its inflation.”

But the pace and extent of monetary policy normalization are controversial – even in the Governing Council of the ECB. Bundesbank President Joachim Nagel can even envision raising key interest rates into the restrictive range, which would actively curb the economy. Nagel belongs to the representatives of the strict monetary policy line (hawks), while the supporters of a more relaxed line (doves) warn of the dangers of a recession, especially as a result of the war in Ukraine. Even among observers the course is controversial.

More than 25 basis points?

So Karsten Junius, chief economist at the Swiss bank Safra Sarasin, is in favor of an interest rate increase of 50 basis points. In this situation, the ECB will no longer have to focus so strongly on its announcements, the so-called forward guidance. Even if the Central Bank initially takes only a small interest rate step. It is important, says Getrud Traud, that monetary watchdogs make it clear that they are ready to keep raising interest rates after September in order to fulfill their mandate. To keep the inflation at the level of two percent, so that the value of the euro remains stable.

However, the current situation is not easy for the supervisors of the euro. On the one hand, they should normalize monetary policy. But if they hold back too hard, they stifle the economy. “In terms of energy prices they can’t change anything anyway,” explains Martin Lück, chief economist for Germany at the world’s largest asset manager, Blackrock, “so then they will have to lower prices for other things, goods and services.”

As if there is no gas

Even without the intervention of the ECB, the risk of recession will increase in the first place, if Russia, on the day when the ECB Council meets, does not open the gas tap again after the maintenance control of the Nord Stream 1 gas pipeline. The “normalization” of the monetary policy will says according to Lück, the approach to the “neutral interest rate”, i.e. the interest rate at which the economy neither accelerates nor slows down.” However, where it currently stands in the euro area is difficult to determine.

The ECB may be under pressure, also because the interest rate differential with the US is widening. After inflation there reached 9.1 percent in June, the US Federal Reserve is likely to raise interest rates by 75 basis points from the current 1.5 percent to 1.75 percent. This continues to put pressure on the euro, which a few days ago had fallen to the level of the US dollar.

And finally, the financial markets are also watching from Italy. The government crisis there does not ease the situation for the ECB. Prime Minister Mario Draghi is still in office, but it is not known how long he will continue like this. There may even be new elections in October. They could lead to “significant turbulence” in eurozone government bond markets if the new government is led by Eurocritics, suspects Edgar Walk, chief economist at Bankhaus Metzler. The ECB has announced a so-called anti-fragmentation instrument. Through this, it wants to preliminarily mitigate possible turbulence in the European government bond markets./DW

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