It’s supply chain issues, the war and a weak currency – until this week, the euro was at its five-year low against a US dollar that has strengthened significantly in response to the sudden introduction of tighter monetary policy by the Fed – driving the inflation rate.
Lagarde called “imported” inflation and described it as a “term of trade tax”. In the past year, she said, the eurozone had transferred 170 billion euros ($257 billion), or 1.3 percent of GDP, to the rest of the world through the net cost (after taking into account more competitive exports) of higher import prices.
The ECB’s policy shift, which saw its balance sheet explode from about €1.5 trillion in 2007 to about €8.8 trillion today, will contribute to the global monetary tightening that is already wreaking havoc on investment markets. The Fed’s balance sheet increased from less than $1 trillion ($1.4 trillion) to about $9 trillion over the same period.
However, the ECB’s proposed measures will help weaken a US dollar that has appreciated rapidly and not just against the euro.
That could provide some relief for emerging market economies and even China, which faced capital outflows and higher borrowing costs and debt repayments on US dollar-denominated debt as the dollar strengthened.
The dollar had appreciated about 8 percent this year against the basket of currencies of its major trading partners, sparking rumors of a new Plaza Accord (a 1985 agreement by the G-5 economies to reduce the value of the then rising dollar) before Lagarde’s blog post.
The dramatic shift in ECB policy, assuming they materialize, is not without risk.
The pandemic has caused significant damage to some European economies that had very weak finances before the COVID outbreak. Over-leveraged economies have added even more debt even as their condition deteriorated.
The post-financial crisis highlights that the eurozone almost fell apart and was centered in southern Europe (remember “Grexit” and “Quitaly”) and they will bear the brunt of higher interest rates than Germany or France with their stronger economic fundamentals.
Greece has a debt-to-GDP ratio of about 185 percent. Italy is about 150 percent, with a budget deficit of about 10 percent of GDP. Portugal’s debt-to-GDP ratio is 122 percent and Spain’s nearly 120 percent.
The potential for a new eurozone sovereign debt crisis is real.
Southern Europe, especially Italy and Greece, were propped up by negative interest rates and the ECB’s bond purchases. The ECB has absorbed almost the entire Italian debt issuance.
The end of quantitative easing and higher interest rates, albeit still at negligible levels, will put pressure on southern European economies and put new pressures on the coherence of the European project and a bloc that almost disintegrated in the wake of the financial crisis. crisis due to the disparate conditions of individual economies.
If the ECB follows up on Lagarde’s comments, the new era of monetary policy will finally come to an end.
The ECB’s negative interest rate — its key interest rate today is minus 0.5 percent — was intended to try to force European lenders to lend rather than pay to deposit their excess cash with the central bank and other financial institutions. deposit to accept more risk in pursuit of positive returns.
The post-financial crisis that nearly tore the eurozone apart was centered in southern Europe and they will bear the brunt of higher interest rates than Germany or France with their stronger economic fundamentals.
The ECB would argue that the policy was successful, although it undermined the already modest profitability of European banks, undermined the solvency of pension funds and produced perverse results by encouraging a cash deluge in negative-yielding assets as investors feared that interest rates would fall further into negative overnight. territory. There were even corporate “borrowers” who were able to build up debt against negative coupons – they were paid to borrow!
That was not entirely unique to Europe. At their peak in 2020, there were nearly $19 trillion in corporate and government debt instruments with negative returns. Today there is virtually none.
If the Fed and the ECB and others (like our Reserve Bank) can pull out of the unconventional monetary policies that the two major central banks have pursued over the past 14 years without blowing up economies and markets (or at least not completely melt down) it would be an important milestone in the progress of the financial crisis to more historically normal institutions.
That “if”, however, looms large for Italy and others in southern Europe, for China and emerging market economies and investors in everything from stocks to crypto assets to bonds – as well as a successful transition and the dramatic tightening of global financial markets. conditions and higher credit costs that would entail. It’s a brave and risky new world.
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