ECB Tightens

The ECB, months after the Bank of England, and US Federal Reserve began tightening monetary policy, has eventually announced that it is to follow suit. If the BoE and Fed, are way behind the curve, the ECB is so far behind it that they can't yet even see it. That also is manifest in the statement they put out with the decision, and in Lagarde's following Press Conference.

The ECB will end its QE programme on July 1st, and will increase its policy rates by a quarter of a point at its next meeting on 21st July. They have also announced that this will be the start of a hiking cycle, with further rises at future meetings, including the potential for a half point rise in September, if the current levels of inflation continue or worsen. Given that, even in their statement, they say that the risks to inflation are primarily to the upside, that seems like baking in at least a half point rise in September.

Yet, their analysis still sees inflation falling from its current 8.3% level to 6.8% for 2022, and then to 3.5% in 2023, and 2.1% in 2024. That, frankly, looks like fantasy, and a triumph of hope over reason. The Eurozone is awash with liquidity. The ECB has bought €3.5 trillion of bonds as part of its asset purchase programme. So far, it has only committed to stopping buying any more, and not even that. In its statement, it says that, if there is fragmentation in Eurozone sovereign debt markets, in other words, if, as in 2010, and 2015, the southern European economies see their bond yields getting blown out, it will again step in to buy those specific bonds, to try to reduce the yields.

Given that it is in Italy, Spain, Portugal, and Ireland that problems with inflation, particularly energy price inflation, as the EU tries to appease US imperialism, by reducing imports of Russian oil and gas, are likely to be greatest, and where higher borrowing costs themselves start to impact debt servicing, the likelihood of the ECB having to do so seems high. But, its ability to do that on a scale sufficient to be effective, especially as any such additional liquidity threatens to just push inflation, in those economies, higher still, seems very restricted.

Back in 2010, as the Eurozone Debt Crisis unfolded, I said that the EU would have to move faster towards fiscal union, with a single debt management office selling bonds for the whole of the region, as happens with the US, UK, and other states. In short, it would mean the EU has to move faster towards establishing itself as a single state, whether as a one and indivisible, unitary state, like France, or as a Federal State, like the US, but with a strong centralised state apparatus. In fact, after 2010, the EU adopted a half-way house approach. It did not bring about fiscal union, but instead sought to make monetary policy carry all the burden. Each country continued to issue its own bonds, whilst the ECB sought to squash yield spreads between them by engaging on what amounted to QE, as Mario Draghi said that it would do “whatever was necessary”, by buying up peripheral economy bonds, and basically giving money away to commercial banks, for them to use to themselves buy up those bonds, and ultimately introducing negative deposit rates, so that any banks depositing money with them, rather than using it to buy up bonds, had to pay for the privilege of doing so.

In fact, as a result of the hit to EU GDP from its insane implementation of lockdowns, after 2020, it has had to respond with a €750 billion fiscal stimulus, package that is centrally funded. It is the first stage of the EU moving to fiscal union, and a rational combination of fiscal and monetary policy. The reality is, as in 2010, if the EU does want to prevent fragmentation, it will have to do so, as just using monetary policy, in an age of high levels of inflation, and monetary tightening, is no longer tenable. In the aftermath of the announcement, Italian BTP's surged by 20 basis points. German 10 Year Bunds, also rose by 10 basis points, meaning that the days of negatively yielding German Bonds, are now well behind us. But, it is the widening spread between those Bunds, and peripheral economy bonds that poses the problem for the EU, and the ECB.

The ECB's forecasts of inflation falling to 3.5% next year, and 2.1% in 2024, insofar as they have any grip on reality at all, are founded upon the idea that its economy will be slowing, as a result of the impacts of inflation itself squeezing household incomes, and causing demand destruction. Its certainly true that the decisions of EU countries, to boycott Russian oil and gas, and other primary products, and so demonstrating its continued subservience to US imperialism, is doing serious damage to the EU economy, not to mention the living standards of its 400 million people. But, the argument depends upon the idea that inflation is simply a consequence of an interaction of supply and demand on prices, so that increased aggregate supply, or reduced aggregate demand will result in lower prices, or prices rising at a slower pace. That is false. There can be both increased supply and lower demand, and yet higher prices, if the supply of money tokens rises faster.

The argument rests upon the idea that household budgets will be squeezed as wages fail to keep up with particularly rising energy costs. The EU certainly has higher levels of unemployment than does the US, or UK, though some of that is due to different methods of calculating the figure, with for example, students being included in the figure. The EU has the advantage over Britain, after Brexit, of a larger, more mobile labour market. However, employment is rising fast in the EU too, and European workers are likely to be pushing for higher wages and getting them, just as much as workers in the US and Britain. As with other aspects of the EU, the situation is different in each country too, with German unemployment at only 3.00%.

As elsewhere, higher wages mean that workers will be able to continue to consume without facing the squeeze on their budgets that the models currently predict, as the basis of slowing economic activity. As China is forced to abandon its ridiculous zero-Covid strategy, which is now clearly being used solely to repeatedly slow down economic activity in a rapidly overheating economy, so global growth will also increase. That means continued expansion of gross output, and an increasing squeeze on net output. To try to enable firms to maintain profit margins, central banks will increase liquidity, so fuelling a continuation of inflation, for the foreseeable future, even as they respond to it, superficially, by continually raising nominal policy rates.

The effect will be an inflation that disguises a continual erosion of profit share as wage share increases, with rising wage share continuing to fuel aggregate demand, and the need for firms to expand, but also a need to fund it via increased borrowing, leading to continually higher costs of capital, i.e. higher market rates of interest, increased supply of shares and bonds, and falling asset prices.