The ECB will go to zero this year, but it has no map beyond that

He prefers to speak of travelers embarking on a “journey to normalize our monetary policy.”

But unlike passengers who embark on a road trip, the ECB embarks on its journey without a map and with only a vague idea of ​​where it wants to land.

As inflation climbs to 7.5 percent and proves surprisingly stubborn, economists at investment bank UBS believe there will be three rate hikes this year, four more next year and possibly more in 2024.

At the end of last week, financial markets were pricing in 91 basis points of rate hikes this year, 98 basis points for next and 15 basis points for 2024, totaling 204 basis points and bringing the deposit rate to 1.54 percent, UBS said.

That’s quite a reversal, and some of Mr de Galhau’s associates are now even calling for a half-percentage-point rate hike at the ECB’s July policy meeting – mirroring Federal Reserve Chair Jerome Powell’s recent pledges of outsized rate hikes , until America has tamed inflation.

There is no doubt that the ECB was too slow to recognize the dangers of inflation, but the euro zone is not America.

Here we have a one-size-fits-all approach to monetary policy – ​​what’s good for Germany is also good for Greece – in a bloc where 19 member states have their own fiscal policies.

Despite repeated opportunities to reform the Stability and Growth Pact, it stands. The pact is in limbo, but Federal Finance Minister Christian Lindner said financial times: “The decision to extend the escape clause should not be seen as a precedent or prelude to fiscal rule reform.”

Despite all efforts at coordination – and the creation of a first joint EU fiscal capacity in response to Covid – we have a group of countries that are genetically incapable of coordinating their policies. There is hardly a monetary policy system worse suited to the modern world than the eurozone.

As Willem Buiter, former Bank of England interest rate setter and former chief economist at Citigroup, recently noted, Greece, Italy, Portugal and Spain are “all fiscally vulnerable” and France, Belgium and Cyprus may also face government financing problems.

This means that while the European Central Bank is trying to raise interest rates to combat inflation, it also has to worry about the vulnerability of the balance sheets of a great many countries to higher interest rates. Not this time in Ireland, however, as the sovereign debt has to be upgraded by Fitch rating agency to complement an earlier one by Moody’s.

While Ireland looks safe, others are not. According to the Institute of International Finance (IIF), a coalition of the world’s leading banks, Bloomberg liquidity indices have been pointing to a steady deterioration since the middle of last year, particularly for peripheral euro countries such as Italy and Spain.

“Overall, the shift in market psychology — with markets less tolerant of policy normalization — means the likelihood of a market breakout has increased,” the IIF said in a recent report.

The economic landscape has changed dramatically since Europe’s fiscal rules were drafted some 30 years ago, and yet the rules of the Stability and Growth Pact remain at their core, although we have seen huge changes in central bank policy, for example.

So why not change the rules of the game after such a long time? Aside from bringing neither stability nor growth, the pact is likely to shift increasing economic burdens to the ECB to stabilize the European economy. That will mean more frequent ECB visits when interest rates are zero. This in turn harms the bank’s ability to fight inflation.

Mr de Galhau acknowledges the bloc’s structural flaws, although he is reluctant to identify them directly, saying that alongside looking at interest rate policy “equally important in the euro area is ensuring an even and smooth transmission across jurisdictions and asset classes”.

He believes that final nominal interest rates of around 1.5 percent in the euro zone and 2.5 percent in the US will be the result of the two central banks’ current interest rate hike paths. That’s still a far cry from pre-crisis estimates of a “neutral rate” of around 5 percent for rich global economies.

The Frenchman obviously likes his motor metaphors, likening the gear increase to reach neutral to lifting “your foot off the accelerator as you approach your desired speed”.

“Only if you actively put the brakes on would the measure be seen as monetary tightening,” he claims.

That’s all fine as long as you know when to hit the brakes or hit the accelerator again. This is not an easy task as the neutral interest rate, also known as the “R-star” to economists, is only an estimate of the policy rate that keeps the economy on a stable path and is not directly observable.

In other words, Mr. de Galhaus’ political map doesn’t really show the upcoming hairpin bend, it’s more like a medieval map with the inscription “Here are dragons” for unknown territory, even if there are no hawks and doves in his universe.

In these circumstances, a smooth deceleration seems less likely than an impact.