ECB rate rise intensifies dilemmas over Europe’s direction

Waning dynamism alongside concerns over lower US support for Ukraine

The European Central Bank’s controversial 14 September decision to go ahead with further interest rate tightening is likely to exacerbate Europe’s policy dilemmas over a flagging economy and the next steps in the war in Ukraine.

The ECB’s 0.25 percentage point hike, which went against arguments from a minority on the 26-member council for a pause in the bank’s 14-month cycle of rate tightening, took the key deposit rate to a record high 4%. This indicates that, for the moment at least, Bundesbank-style anti-inflation stubbornness has gained the upper hand over the view that inflation will anyway descend rapidly as economies cool across Europe.

The rate rise will do nothing to allay concerns about waning European dynamism. It came a day after a meeting of the OMFIF advisory council highlighted the risks to Europe of increasing exposure to the fall-out of the war in Ukraine, amid flagging American support for further fighting as the US presidential election campaign gets under way.

Worries over political polarisation across the West, the slowdown in China and fears over a continuation of the Ukraine conflict were among the main preoccupations at the OMFIF advisory council meeting on 12 September.

Participants pointed to an apparently growing gap in the West between the ‘big picture’ pronouncements of politicians on issues like reaching net zero commitments and everyday voters’ complaints over inflation and immigration. This is diminishing appeal for mainstream politicians and adding to support for protest parties across Europe. This is seen in difficulties assailing French President Emmanuel Macron and German Chancellor Olaf Scholz as well as the rise to power of Italy’s Giorgia Meloni. The anti-euro, anti-immigration party Alternative for Germany (AfD) is polling higher scores than Scholz’s Social Democrats, casting a blight over a string of important elections in eastern Germany next year.

A counterweight to gloom over Europe was confidence among US participants that America would not face a serious downturn in spite of continued Federal Reserve monetary tightening. The much-heralded ‘soft landing’ is now looking like reality, one council member said on 12 September. However ‘culture wars’ in the US were likely to overshadow the election campaign and influence America’s ability to continue to manage and help finance the war from the sidelines. The outcome might leave the Europeans next year with the worst of all worlds: sluggish growth, relatively high inflation, continued vulnerability to geopolitical turbulence in the East and sagging American desire to assist in Ukraine-related burdens.

There was a strong belief at the OMFIF meeting that relatively high inflation, high interest rates and high public debt represented a state of affairs that might persist for several years. One seasoned central banker said the world was ‘leaving an era of plenty, about to enter era of scarcity’. Positive supply-side shocks from the past were now going into reverse. Demographics, climate change, misallocated investments and problems accumulated since the 2007-08 debt crisis were raising questions about government debt sustainability in key countries. This would become a still more pressing issue if borrowing rates remained at present levels, well above the ‘cheap money’ conditions when much of the debt was contracted.

Participants spoke pessimistically about a world of ‘fundamental uncertainty’ impervious to contingency planning. These included measures for countering climate change and the related shift in emphasis for commodity sourcing – away from fossil fuels to metals. It was pointed out that a large proportion of such metals are being refined in China, which could put further pressure on the West. Climate change policies require additional investment at a time when workers will be in shorter supply because of demographics. ‘A lack of workers needs to be met with new investment. We are going to have shortage of supply at the same time as an increase in demand,’ said one delegate.

On the debt side, it was pointed out that a generation of managers in financial institutions and elsewhere has little experience managing high nominal interest rates and high inflation. The idea that ‘markets will absorb’ public deficits in due course was illusory since it postponed today’s issues until tomorrow. Linked to concerns about global debt vulnerabilities is a perception that the Paris Club of international creditor nations is losing influence as a result of geopolitical shifts changing the balance of risk and reward among borrowers and lenders.

David Marsh is Chairman and Taylor Pearce is Senior Economist of OMFIF.

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