The balance of power at the European Central Bank has shifted decisively in favour of hawkish officials determined to tackle the risk of inflation spiralling upwards, despite fears that the war in Ukraine could drag Europe into recession.
Several ECB governing council members argued at Thursday’s meeting that it should wait before speeding up the withdrawal of its bond-buying stimulus due to uncertainty over the economic fallout from Russia’s invasion of Ukraine. But they were outnumbered by more hawkish voices.
“The argument about inflation dominated and prevailed over anything else, including the war, the uncertainty and the fears about growth,” said one person involved in the meeting.
“The risks of inflation are now seen as greater than other concerns by a majority of the council,” the person said, after the ECB announced it planned to stop net bond purchases in the third quarter in response to the recent surge in prices of energy and many other goods.
Consumer prices in the eurozone have risen faster than the ECB expected for several months, hitting a record annual pace of 5.8 per cent in February. On Thursday, the ECB raised its forecast for inflation this year from 3.2 per cent to 5.1 per cent, citing the “exceptional energy price shocks” stemming from the war in Ukraine.
A second person involved in Thursday’s meeting said: “It is getting clearer and clearer to more of my colleagues that the transitory story on inflation is a bankrupt story.”
“It is not just oil and energy prices that are rising fast, you have food, non-energy industrial goods and services all accelerating at more than 2 per cent,” said the second person. “We have to do something — we cannot be the only central bank not reacting.”
The US Federal Reserve is expected to start a series of interest rate rises at its meeting next week, while the Bank of England raised interest rates at its last two meetings and the central banks of Canada, Brazil, Mexico, South Korea, Chile and Poland have also raised rates.
A third person briefed on the ECB’s meeting said the more hawkish voices calling for more immediate action on inflation outnumbered those advocating patience by 15 to 10.
A key factor shifting the ECB’s debate in a more hawkish direction was a chart given to governing council members showing market inflation expectations had risen by a record amount since the ECB’s last policy meeting, as measured by inflation swaps, according to two people involved.
Christine Lagarde, ECB president, said at a press conference after Thursday’s meeting “there were different views around the table — in all directions” but in the end everyone decided to “rally” behind the decision.
Eurozone government bond markets sold off on Thursday after the ECB presented plans for a quicker reduction in its asset purchase plans this year, under which it would reduce bond purchases to €40bn in April, €30bn in May and €20bn in June. Its earlier plan had been to reduce net purchases more slowly from €40bn a month in April to €20bn a month from October.
It could completely stop adding to its existing €4.8tn bond portfolio in the third quarter “if the incoming data support the expectation that the medium-term inflation outlook will not weaken even after the end of our net asset purchases”, it added.
Only a major escalation of the war in Ukraine, cutting off the supply of Russian energy to Europe and causing significant disruption to financial markets, would deter the ECB from stopping net asset purchases as planned, the two people involved in the meeting said.
The ECB published three sets of forecasts including an adverse and a severe scenario as well as its baseline scenario. The downside scenarios modelled the likely impact of cuts to Russian energy supplies to Europe, increased geopolitical tensions and financial market disruption.
In the severe scenario it predicted eurozone growth would be only 2.3 per cent this year, down from 3.7 per cent in its already-lowered baseline scenario, while inflation would soar to 7.1 per cent, compared to a baseline projection of 5.1 per cent.
“We discussed the possibility of a stagflationary shock, not actual stagflation, as we are not talking about negative annual growth,” said the second person involved in the meeting. “But the threat of inflation was seen as more immediate and real.”