The decision is made. The ECB will also raise interest rates now that inflation is showing few signs of cooling. But this also increases the risk of a classic policy mistake.
An important reason why the ECB, after a long hesitation, wants to raise interest rates after all, is the “Supercore” inflation rate. This is the level of inflation without the well-known volatile components of energy and food, but also without items that are driven by one-off price adjustments, are highly volatile and are strongly influenced by external macro-economic conditions. All items over which the ECB has no influence, therefore.
The chart above shows that Supercore inflation also rose sharply in April, while headline inflation remained flat at 7.4 percent. Underlying inflationary pressures are therefore still rising.
A classic policy mistake?
The ECB is going to raise interest rates at a time when consumer confidence has already plummeted due to soaring prices, business confidence is also falling, China is still largely locked in, and dependence on Russian energy is still particularly high. It does not take much to push the eurozone economy into recession.
As a result, the ECB is likely to make a mistake like in 2008. Then the central bank raised interest rates just before the Lehman bankruptcy brought the financial system to the brink of collapse. Shortly afterwards, all the ECB had to pull out all the stops, including a cut in interest rates to almost zero percent, to keep things together.
Recession lurking
I am not saying that we will have a Lehman-type situation, but the possibility of a recession should certainly not be underestimated. A recession is a painful but very effective way to bring down inflation. Moreover, if there is a deep recession, I think the ECB will do exactly what it has done in the last 12 years since the financial crisis: cut interest rates, if at all possible, and start buying government bonds again.
I also expect the liquidity-addicted market to protest by, for example, increasing the Italian bond spread. We are already seeing this happen. A widening spread means less favourable financing conditions, something Lagarde will not be happy with.
The July rate hike will happen, but after that it remains to be seen.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His “chart of the week” appears every Monday on InvestmentOfficer.lu.
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