Christine Lagarde’s European Central Bank (ECB) has not one but two missions — an official mission to keep inflation at no more than 2%, and an unofficial mission to prevent the collapse of the euro by keeping heavily indebted eurozone countries such as Italy afloat.
By driving up energy and food prices and increasing the risk of another European economic downturn, Russia’s invasion of Ukraine makes it very difficult for Russia to carry out its two missions simultaneously. ECB. This will likely keep the Euro down in the period ahead.
Even before the Russian invasion, the Eurozone had a serious inflation problem due to COVID-19 related supply shocks combined with the extraordinarily accommodative monetary policy stance of the ECB. Over the past year, consumer price inflation has increased to a record 5.8%, nearly three times the ECB’s inflation target. It did so at a time when the ECB maintained a policy of negative interest rates and was engaged in a bond-buying program of unprecedented magnitude.
The spike in international energy, food and metal prices following the Russian invasion is sure to send already high inflation into the Eurozone significantly. This is particularly the case given Europe’s heavy reliance on Russian natural gas imports for its energy needs, as well as the very rapid rate at which natural gas prices in Europe are rising. While international oil prices have risen by around 60% since the start of this year, European natural gas prices have tripled.
If sustained, soaring energy prices in the Eurozone have the potential to push the Eurozone economy back into recession. Unlike the United States, which has become energy independent, the euro zone is highly dependent on imports for its energy needs. This means that the rise in energy prices in Europe is in fact a tax on the European consumer, which is not nearly offset by a revival of the European energy sector as is the case in the United States.
Even before the eurozone was hit by the Russian energy price shock, Italy, the eurozone’s third-largest economy, had very worrying public finances. During the pandemic, its budget deficit exploded and its public debt soared to an all-time high. At the end of 2021, Italy’s public debt-to-GDP ratio was around 155%, its highest level in Italy’s 150-year history. The last thing Italy needs is another economic recession, which would make its public finances even more unsustainable.
Over the past year, despite seemingly unsustainable public finances, the Italian government has been able to finance itself easily at very low interest rates. This was largely thanks to the 1,850 billion euros from the ECB Pandemic Emergency Purchase Program. Under this programme, the ECB purchased €250 billion of Italian government bonds, equivalent to the total net financing needs of the Italian government.
Russia’s invasion of Ukraine now greatly complicates the life of the ECB, both by worsening inflation and by raising the specter of a new European recession which would further compromise Italian public finances.
This places the ECB before an unpleasant political choice. The ECB may tighten the brakes on monetary policy to control inflation, but at the risk of triggering a new cycle of Italian sovereign debt crisis. Alternatively, it can keep its pedal to the metal of monetary policy by expanding its bond-buying program and maintaining negative interest rates. This would keep a heavily indebted Italy afloat, but at the risk of losing control of inflation.
If the past is prologue, the ECB will do everything in its power to prevent the breakup of the euro. It will do so even though it may involve the risk of a prolonged period of high inflation and weakening of the currency. Since the beginning of the year, sensing that the ECB would pursue a looser monetary policy than the Federal Reserve would, the markets have caused the euro to fall by around 10% against the dollar. The Russian invasion is now likely to keep the euro on its feet for some time to come.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department at the International Monetary Fund and Chief Emerging Markets Economic Strategist at Salomon Smith Barney.