Christine Lagarde’s Inflation Challenge

T he latest European Central Bank (ECB) meeting reminds us that Christine Lagarde’s ECB never fails to disappoint. Faced with the highest euro-zone inflation rate since its 1999 founding, the ECB’s policy response fell miserably short of what was needed in the circumstances. This does not bode well for the ECB’s prospects for bringing inflation back under control or for avoiding another round of the European sovereign-debt crisis.

In the wake of the Covid pandemic and Russia’s invasion of Ukraine, the ECB has been confronted with two basic economic challenges.

First, fueled by the spike in energy and food prices, inflation in euro-zone consumer prices has skyrocketed to a record 8.1 percent — four times the ECB’s 2 percent inflation target. Second, there has been a major deterioration in the public-debt position of the European economic periphery in general and that of Italy in particular. That has now driven the spread between Italian and German government bonds to more than 240 basis points, or to its highest level since the pandemic began some two years ago.

After having been in inflation denial over the past year, the ECB has finally taken some tentative measures to address the inflation problem. It announced that beginning on July 1, it will cease its bond-buying activities and will raise interest rates by 25 basis points. It also announced that it will again raise interest rates at its September meeting, perhaps by more than 25 basis points depending on how inflation develops.

While the ECB’s move on interest rates at least constitutes a start to what is likely to be a long interest-rate-hiking journey to regain control over inflation, it is far from obvious that it will make much of a dent on inflation. After all, even after the ECB’s proposed move, the ECB’s interest rates will still remain a negative 25 basis points — at a time when inflation is above 8 percent.

To its credit, the ECB recognizes that the inflation risks could be to the upside if the global supply-chain disruptions get worse and if the Russian war drags on. In that case, euro interest rates would become even more negative in inflation-adjusted terms than they are today.

The ECB would also seem to have come up short in taking adequate policy steps to prevent another round of the euro-zone sovereign-debt crisis that could be precipitated by the marked deterioration in Italy’s public finances. This is all the more to be regretted considering that in the wake of the pandemic, Italy’s public debt-to-GDP ratio skyrocketed to more than 150 percent, its highest level on record. It is also to be regretted considering that Italy is the euro zone’s third-largest economy and around ten times the size of the Greek economy. This makes Italy too big to be allowed to fail if the euro is to survive in its present form. However, it also might make Italy too big for the rest of the euro zone’s members to keep bailing it out.

Up until now, despite its poor public finances, Italy has been kept afloat by the ECB’s massive bond-buying program. Under that program, the ECB bought around EUR 250 billion in Italian government bonds, or more than the Italian government’s net borrowing needs. Now that the ECB is scheduled to stop its bond-buying, markets are already questioning how the Italian government will finance its massive borrowing needs, a worry that’s being reflected in a marked widening in the Italian bond spread.

It would seem highly doubtful that the ECB’s assurances that it will use flexibility in reinvesting maturing bonds under its Pandemic Emergency Purchase Program will prevent markets from continuing to sell Italian bonds. Given the size of the Italian government’s borrowing needs, markets would likely need to see concrete ECB steps in the form of new programs to back up its claim that it will do whatever it takes to keep the euro together.

In central banking, lost confidence is difficult to regain. This makes it imperative that the ECB move more swiftly than it is now doing to raise interest rates and to introduce new support programs for the euro zone’s troubled periphery. If not, the Lagarde ECB risks going down in history as the one that allowed inflation to get out of control and that paved the way for another round of the European sovereign-debt crisis.