Late last weekthe European Central Bank raised eurozone interest rates by 50 basis points. That was its first rate rise since the short-lived and ill-fated attempt to normalise its rate structure in 2011,which precipitated an existential crisis in the European Union which only abated when it reversed course and Mario Draghi vowed to do “whatever it takes” to restore stability and keep the EU from falling apart.
A weakening of the euro relative to the US dollar is exacerbating the impact of the energy crisis of a Russia-dependent Europe – oil and gas are priced in US dollars – while raising the cost of imports more generally and offsetting any benefit to exports. Even Germany,an export powerhouse,is posting trade deficits for the first time in decades.
The ECB,very sensitive to the spectre of fragmentation – weaker and over-leveraged economies in southern Europe being forced into financial crisis and facing domestic pressures to exit the eurozone by a blow-out of the spreads on their debt – has created a new/old policy tool to respond to that threat.
It’s new “Transmission Protection Instrument,” or TPI,is another bond-buying program that will enable the ECB to keep a lid on the sovereign debt costs of economies like Italy’s,although the criteria for intervention remains (one suspects deliberately,to keep market participants guessing) vague.
Even with the 50 basis point increase,double what the ECB had previously flagged,the Europeans are a long way behind a curve that is now being set by the Fed.
If the Fed does what bond traders expect and raises US rates by 75 basis points this week the federal funds rate target range will be 2.25 per cent to 2.5 per cent and will be on track to end the year around 3.5 per cent to 3.75 per cent.
The ECB’s benchmark deposit rates is now 0 per cent and the Reserve Bank’s cash rate 1.35 per cent,with market expectations that the cash rate will be closer to 3.5 per cent by the first quarter of next year.
The Fed is now moving aggressively and forcing other central banks to follow suit if they want to muffle the inflationary effects of lower exchange rates.
That’s a lot of painful decision-making for the ECB,RBA and their peers if they are to avoid too wide a divergence in monetary policies with the Fed and the currency depreciation and outflows of capital they could provoke.
The pressure is most acute in Europe where the yields on debt issued by Italy and Greece are already above 3.2 per cent,with the spread between the yields on their debt and Germany’s bunds,which yield about 1 per cent,now above 200 basis points.
The political dysfunction in Italy afterthe collapse of Draghi’s administration last week;its debt-to-GDP ratio of about 150 per cent and its status as the third-largest of the EU economies mean its finances and the interest costs of its debt will be of most concern to the ECB. If the TPI is to be deployed Italy is likely to be the major beneficiary.
While conditions in Europe have been made significantly worse by the impact of Russia’s invasion of Ukraine on energy supplies and costs,at a macro level it is a familiar picture.
Italy and Greece,with their unstable politics,poor economic management and debt levels that are unsustainable in a normalised rate environment – an environment not experienced since the 2008 financial crisis – are acutely vulnerable to rising rates and,if the eurozone is to remain intact,have to effectively be bailed out by the stronger northern European economies.
Those bailouts come with harsh conditions of the type that nearly led to “Grexit” and “Quitaly” andthe fracturing of the eurozone.
The Fed and other Anglosphere central banks and governments don’t have to deal with that existential challenge but are still going to have to impose pain on their communities (and raise their governments’ interest costs significantly) to bring inflation rates down to sustainable levels.
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Bond traders in these markets are pricing in rapid fire increases in rates but relatively short but sharp recessions before interest rates start to fall,and their economies to resume more normal growth settings,by the middle of next year.
By then,with China considering some relaxation of its overly-rigid response to COVID outbreaks and,hopefully,some resolution of the war in Ukraine,the supply-side issues might have abated. That’s the optimistic case.