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Inflation continues to wreak havoc on the global economy with inflation reaching a 40-year high in the US last week at 9.1%, despite the Federal Reserve raising interest rates by 150bps, to 1.75%, in a matter of months. Looking at Europe, the United Kingdom is in a similar predicament with 9.1% inflation and interest rates now at 1.25%. In contrast, the EU is in a more precarious position, given the reliance on Russian energy exports. Yet despite inflation running at 8.6%, the European Central Bank (ECB) continues to hold interest rates at negative 0.50%; yes you read that correctly. ABSI analyses the ECB’s monetary policy and the issues with a monetary union. 

The European Union (EU) is a political and economic union with 27 member states and a common fiat currency that is the national currency of 19/27 members, the Euro. The Euro was first introduced in 1992 through the Maastricht Treaty and came into existence on January 1st 1999. Interestingly, EU members Denmark and the UK did not adopt the currency and opted to keep their own currency. The reason for this identifies the biggest flaw in the Euro; relinquishing control of the currency means abdicating control of monetary policy to a 3rd party.

The ECB is the overseer of the Euro currency through its various decision-making bodies. The governing council is responsible for setting monetary policy (interest rates) on the Euro and comprises the 19 national central bank governors that use the Euro and the ECB Executive Board, which is a 6-member board, elected by the European Council, responsible for the implementation of monetary policy. The governing council holds 8 meetings each year, every 6 weeks, to discuss monetary policy and set interest rates and the next meeting is this Thursday 21st July.

The next monetary meeting is a big one, as it is guaranteed that the ECB will raise interest rates for the first time in 11 years. However, despite the current rate of inflation, the ECB has indicated to the market to expect a 25 bps hike to negative 0.25% for the deposit facility. This result is bewildering considering that central banks around the world are hiking as high as 1% at a single meeting.

 

Source: MishTalk

Unequivocally, the reason for this muted response is the primary criticism of the Eurosystem in that the ECB is setting monetary policy for 19 different economies all currently navigating the current economic environment with differing success. This is highlighted in the increase in bond spreads of Germany, the largest and safest economy, versus that of the PIGS (Portugal, Italy, Greece, and Spain). This spread represents an increasing credit risk being priced in by market participants for the EU economies with the highest debt levels.

Source: European Commission

A team is only as strong as its weakest link, and the ECB, through its monetary policy actions, is helping to prop up and monetise the debt of some of the worst performing EU economies. As a result, they’re putting pain and pressure on the best economies and this is demonstrated in the Euro exchange rate. Last week, the Euro went to parity with the US Dollar for the first time in 20 years and this is happening across the board with other currencies. Proponents will argue that a weaker currency will encourage exports and tourism, however, a weaker currency also raises the cost of imports which will further stoke the fires of inflation as the EU balance of trade is in a deficit. The overall effect of this is lower purchasing power for EU citizens which may see migration of labour out of the system; nobody wants to work for a weak currency.

Source: Ceic Data

In the end, the primary mandate of the ECB is price stability - “price stability is the best contribution that monetary policy can make to economic growth” - given current actions, it is clear the ECB is derelict in their directive and, long term, will exacerbate the fallout of the current economic crisis. Ultimately, this runs the risk of redenomination and the potential breakdown of the whole Eurosystem!

Read the Conversation:

Jack Colreavy:

“ I don't need to tell you that inflation continues to surge month on month. You've probably seen that in the news, but what's encouraging to see is a lot of central banks around the world are starting to raise interest rates aggressively in order to combat this, which is a good result. The one outlier, well the major outlier is the European Central Bank who continues to hold interest rates at negative 50 basis points, despite inflation running at 8.6%. Now, this is highly unusual because the ECBs mandate is for price mobility with the website saying that price stability is the best contribution that monetary policy can make to economic growth. The ECB will meet this week and it is highly likely that they'll raise interest rates for the first time in 11 years, but the expectation is for only a 25 basis point increase, which still means negative interest rates. Now the main reason why they're keeping interest rates so low is the main problem with the EU in general, and that is how do you set monetary policy for 19 different economies? To learn more, subscribe to As Barclay Sees It by clicking the link in the description.”

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