ECB President Christine Lagarde’s inflation battle is making the Fed’s job look like child’s play

Just a quarter point of rate hikes separates the European Central Bank’s (ECB) two main options in this week’s decision, and yet few would envy Christine Lagarde for her job.

This binary choice of half a point or an unprecedented 75 basis points of monetary tightening hides an ever-growing litany of challenges for the ECB President and her colleagues in Frankfurt as they manage a fragile currency area with a war raging next door.

The region’s battered and unequal economy is being plagued by an energy supply crisis, a consequent historic inflation shock and the looming threat of a subsequent recession. Those challenges became even more acute late Friday when Russia’s Gazprom said its key gas pipeline would remain closed indefinitely.

Officials are also grappling with euro weakness, spurred by the impact of aggressive US tightening — and they know that any move by the ECB to offset this by raising borrowing costs is eroding the fiscal stability of weaker members like Italy. While Federal Reserve Chair Jerome Powell’s task of taming inflation in the world’s largest economy is no easy one, given the difficulties facing his European counterpart, Ms Lagarde can rightly claim to have drawn the shortest straw to have.

“The ECB is walking a very, very fine line,” Emmanuel Cau, head of equity strategy at Barclays Bank, told Bloomberg Television. “The Fed needs to slow the economy to bring down inflation. I think the work of the ECB is much more complex because obviously there is not much they can do about an energy crisis.”

Thursday’s decision is less complicated than July’s, but no less momentous.

Then the ECB ended eight years of below-zero interest rates with a surprise half-point move and a new tool to shield debt-ridden Italy as borrowing costs rise.

A 75 basis point hike this time would signal investors the increasing urgency to fight rising prices.

Analysts at Bloomberg Economics said a 75 basis point hike is “far from a done deal and concerns over financial stability will make some policymakers hesitate.”

Inflation is at a record 9.1 percent in the eurozone, with underlying pressures also building.

Russian energy supplies could grind to a halt this winter, potentially crippling the economy and freezing many families to death. “German manufacturers are already closing their shops because of the high costs,” says Sarah Hewin, Head of Europe and Americas Research at Standard Chartered Bank. “For the ECB, this major conflict between fighting ever-higher inflation in the face of an inevitable recession is very difficult.”

While chief economist Philip Lane says such a compromise will be “a big problem”, some colleagues are clearly in favor of a firm fight against inflation. Several recently suggested a more aggressive 75 basis point hike rather than simply repeating the half point move in July.

Last Wednesday’s inflation data gave them further encouragement, and Bundesbank President Joachim Nagel reacted within minutes, urging a “big hike” in interest rates. Austrian Governor Robert Holzmann told Bloomberg there was “no reason to show any kind of leniency”.

A 75 basis point move would match the Fed’s recent pace, but the nature of the shock in Europe is different. Despite similar inflation rates, a supply tightening is the dominant driver in the EU, while demand is stronger in the US.

Since January 2021, more than six percentage points of the rise in euro area inflation has reflected energy and food.

According to calculations by Bloomberg Economics, it is just over half of them in the USA.

Central bankers know that it is much easier to counteract a demand shock with higher interest rates than when supply is the driver.

Adding to the ECB headache, the Fed’s tightening, which encouraged investors to buy the dollar, has pushed the euro below par with the US currency – itself feeding inflation from higher import costs.

The integrity of the currency area is also a cause for concern. Concern is centered on Italy, where this month’s election could install a government led by Giorgia Meloni whose post-fascist roots have unsettled investors.

Although Ms Lagarde can use her newly developed crisis tool to keep borrowing costs under control, “significant uncertainty remains over how this will be used and particularly how market dynamics will be assessed by the ECB,” he said.

EU finance ministers will meet on Friday with Ms Lagarde in attendance, while the bloc’s energy ministers will meet on the same day.

“What the EU decides now, for example, about releasing electricity prices and natural gas prices, will probably have a much greater impact on inflation in the next six months,” said Holger Schmieding, an economist at Berenberg in London.

“Interest rates play a role. In normal times they are very important, but right now they are not the most important thing.” ECB President Christine Lagarde’s inflation battle is making the Fed’s job look like child’s play

Fry Electronics Team

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