Javier Arce| Central banks have gone from sustaining aggregate demand by all means (huge injections of liquidity, even at negative rates) to strangling it, to suffocating it by raising interest rates and draining funds which, also at any price, are now seeking to reduce inflation.
So Europe is already suffering from textbook stagflation: it has been flirting for months with recession while inflation, which was supposed to be transitory, has become “sticky” (and wage rises such as those in Germany, above 6%, bear witness to this).
In Europe, growth has already been stifled but inflation has not yet been brought down. So it is worth remembering now what the textbook says: all money injected into an economy inexorably turns into growth… or inflation.
The money injected over the years, indeed since the 2007 crisis, is still there. The draining process has only just begun. And growth has already stopped… if the standstill is prolonged, are we not forcing it all into inflation?
The minutes of the July meeting of the ECB Governing Council state that several members “expressed concern about the risk of stagflation”. The truth is that the eurozone is stagnating. It was stagnant already between October last year and March this year. In the second quarter of this year 2023 it managed to grow – 0.3% quarter-on-quarter – but everything seems to indicate – PMIs, Sentix, ZWE… – that in the third quarter it has stopped again. The rapid rise in interest rates that the ECB began on 21 July 2022, which in nine steps has taken them from negative territory to 4.25%, has stifled growth.
The European locomotive, Germany – with world trade not helping, and not growing at 2% – is in recession. France has registered 0.1 in the last quarter of 2022 and the first quarter of this year while Italy registered -0.4% in Q2 this year… Growth in the eurozone has certainly slowed. But inflation, having halved from its peak, is still above 5%.
Bringing inflation down without moderating the pace of growth seems to be a mission impossible. But the US had inflation of 3.2% this summer (up from 9% a year earlier) with growth of 0.5% in the second quarter (2.4% annualised). An even balance sheet, one that is very different from that of the euro area today.
BEHIND THE CURVE
In an exercise in realism, the minutes of the European Central Bank reveal that its Governing Council does not expect inflation to be controlled at around 2% until 2025. If it is right, it will have taken three years to achieve this, because the hikes did not begin until the summer of 2022, many months after inflation – “transitory”, I am sure you remember – had shown its credentials. In fact, at the beginning of 2022 Lagarde – still committed to strengthening demand and growth – ruled out rate hikes for the year, although in February, even before the invasion of Ukraine, Spain was already recording inflation of 6%. Then, of course, came the rush.
Between Trichet raising rates at the wrong time and Lagarde not raising them when it was due, the Governing Council of the European Central Bank has already made some serious mistakes in its less than 25-year history. It is relatively easy to assemble a data salad to justify almost anything, but the fact remains that the ECB has been way behind the curve in this price crisis and it remains to be seen that with a half-assembled eurozone – without a risk-free asset, without clear resolution rules and a common deposit guarantee fund with the risk of fragmentation always on the horizon – the pain that the eurozone will have to suffer in order to curb inflation will not be greater than what the ECB Governing Council is now predicting. A council that – it is only fair to insist – must work on an experiment that the political powers that be insist on keeping half-finished.
€3.6 TRILLION IN EXCESS LIQUIDITY
Against this backdrop, the European Commission has just lowered its growth forecast for the eurozone from 1.1 to 0.8% in 2023. Growth achieved with consumption almost frozen, like exports, and based on public spending and investment. Faced with the worsening outlook, analysts at JP Morgan on 4 September reflected the general sentiment when they noted that “Eurozone data in August pointed to a complicated combination of persistent inflation and weakening activity… Investors now expect the ECB to cut rates in the first half of next year, but we see a risk that these hopes will be dashed in the absence of a substantial deceleration in underlying price pressures”.
With the added problem that these “underlying price pressures” now derive, as explained by Isabel Schnabel – member of the ECB Governing Council – from domestic factors, such as wage increases above 6% in Germany (when the eurozone has an all-time low in unemployment, at around 6%, which has allowed a wage increase of over 4% in the area…).
On 29 August, Morgan Stanley analysts noted that “Yesterday’s money supply release (M3: money in effect + demand deposits + savings deposits + time deposits) showed a -0.4% year-over-year decline in July, in line with the lowest level seen since the financial crisis, and the second time in history it has gone into negative territory year-over-year…”
And the rise in interest rates has also pushed down the demand for and granting of credit in the eurozone, which sees credit to the private sector growing at just over 1% (when in September 2022 it was still growing at 6% and was growing at 3% in 2018-19, before the pandemic) and is already showing contraction in the peripheral countries (-2.4% in Spain, -2.2% in Italy).
So, some very complicated months lie ahead for the European economy, which, at Germany’s urging, is seeking to regain fiscal discipline in 2024 and begin to align fiscal policies with monetary policy, after many months of playing against the tide.
In this context of stagnation with inflation, it seems complicated to speed up the essential liquidity drain – it is estimated that excess liquidity is already “only” €3 trillion – which the ECB has already begun to implement, basically by forcing the repayment of TLTRO programmes. The reduction of the balance sheet, which now exceeds €1.6 trillion, has taken the ECB’s balance sheet from 58% to 52% of GDP and will continue in the coming months, supported mainly by the maturities of the ECB’s cheap financing programmes together with a reduction of the APP of €27 billion per month on average. Here the ECB is ahead of the Fed, which would have reduced its balance sheet by $1 trillion if the reversal forced by the collapse of the SVB had not reduced the drain to $850 billion.
