As in 2008, the ECB Has Failed in Its Fight to Prevent Inflation in 2022.

"Inflation is like toothpaste. Once it's out, you can hardly get it back in again. So the best thing is not to squeeze too hard on the tube."

When talking about inflation in the eurozone, it is impossible not to start talking about the Eurosystem and try to understand its mission. In the Eurozone, interest rates influence the economic situation and price stability. It is the Eurosystem that is responsible for defining and implementing the single monetary policy of all countries that have adopted the euro.

The Eurosystem comprises the European Central Bank (ECB) and 19 national central banks of the European Union that use the euro. All of these banks have several missions aimed primarily at maintaining price stability, i.e. keeping inflation close to, but below, 2% over one year.

But since 2008, this mission is no longer respected. Monetary policy contrary to the Maastricht Treaty has been to prevent its weakest members from leaving the monetary union or to avoid financial fragmentation of the eurozone.

Inflation and the 2008 crisis shock

In July 2008, the European Central Bank raised its main policy rate by a quarter point to 4.25%. This decision was expected as inflation had reached 4% in June 2008 in the Eurozone. On the eve of the biggest financial crisis, this resolution was predictable but untimely.

At that time, the ECB was very quickly concerned about rising oil and food prices. Raising rates was a way to mitigate inflation. The crisis was in its early stages and growth was starting to slow down. The rate hike worries member states because it comes at a time of global economic slowdown with a strong euro.

“We believe that what we have done today will ensure price stability in the medium term,” said ECB President Trichet at the time.

With 1 euro = 1.5775 dollars on July 1, 2008, inflation at 4% and a key rate of 4%, was it necessary to increase this rate further? The ECB was subsequently forced to reduce the interest rate considerably, to avoid an economic disaster.

In 2008, the financial shock shook the eurozone and forced the ECB to take over the financing of current account deficits and capital movements from the banking system. This massive intervention succeeded, but at the cost of increasing public deficits in most countries. And it is naturally the most indebted countries that have had to endure defragmentation.

The European Central Bank is lowering interest rates to zero, injecting liquidity, and buying public and private debt. The ECB injects 4,000 billion euros from 2011 to 2017.

Did the ECB make mistakes in 2021 and 2022?

One would have thought that the ECB would learn from its experience. No such luck. After a first rate hike in July 2022 of 50 basis points, on Thursday, September 8, 2022, the European Central Bank announced a 75 basis point increase in its key rates. The ECB intends to return to its 2% inflation target.

But is this objective still achievable in the short term given the geopolitical situation and the surge in energy prices?

The ECB is doing an about-face and implicitly acknowledges its mistake! After having largely underestimated this post-COVID inflation tsunami, the ECB is reversing its position: inflation is now long-term and should increase further. A good hope that inflation will do the opposite, as the ECB does not have a good view.

Should we raise interest rates again? This is a suicidal mistake, according to some experts, because the investment will slow down and the world economy will go into recession. All indications are that the ECB has certainly waited too long. The ECB kept its interest rates at zero and even negative for the overnight rate. This delay created a real inflationary spiral. It is obvious that inflation, initially created by shortages, will be fueled by rising prices and wages.

Low-interest rates are making European banks vulnerable. “Although the low-interest rate environment is supporting the economy in general, we also note an increase in risk-taking that could eventually pose challenges to financial stability” (Luis de Guindos ECB Vice President on 11/20/2019).

With a weak euro at 0.9677 dollars (September 26, 2022) and an inflation rate in Europe of 10.1% in August 2022, the depreciation of the euro against the dollar has an immediate, hard-hitting consequence: it fuels inflation.

After all this delay, targeting inflation and keeping spreads relatively low for highly indebted Eurozone countries seems very difficult. This is the case for Italy, especially after the September 25, 2022 elections. Financial fragmentation remained limited in 2008-2009. It reached very high levels during the sovereign crisis of 2011-2012. It has receded since the ECB announced an unlimited intervention in the debt market of the eurozone states in the face of the high-risk premiums demanded. It should explode sharply if the ECB wants to fight inflation.

To avoid this situation, the ECB has announced a new “anti-fragmentation” tool for the eurozone, the Transmission Protection Instrument (TPI). This instrument will allow the ECB, under certain conditions, to buy financial securities, notably public and private bonds, issued in countries experiencing a deterioration in their financing conditions.

The ECB is forced to move forward with great imagination and innovate very quickly.

The ECB's poor analysis

The inflation rate in the Eurozone jumped in September 2021 to 3.4% year-on-year, the highest in 13 years. In October, the inflation rate rose to 4.1% and then to 4.9% in November 2021, with growth expected to be less than 4.2% for 2022 and 2.9% for 2023.

Why did the ECB Governing Council conclude at the time that monetary easing was still necessary?

In its statement presented at the December 16, 2021 press conference, however, the European Central Bank judges that “monetary support remains necessary to stabilize inflation at its 2% objective over the medium term.” The ECB still senses that inflation would remain low in 2023, which pushes it toward a slow and damaging normalization.

In January 2021, almost a year before the December 2021 meeting, at a time when inflation was on the rise (0.9% in January 2021 vs. -0.3% in December 2020) with strong growth (forecast +3.8% in 2021), it was difficult for economists to see what motivated the ECB to extend its forward guidance on net APP purchases beyond October 2022.

The APP or Asset Purchase Programme is officially intended to stimulate inflation to meet and not exceed its 2% inflation target. Following the scheduled end of the program (PEPP) in March 2022 (emergency pandemic purchase program) the ECB surprisingly announces an increase in net purchases of the APP for 2022: “Based on our updated assessment, in an uncertain environment, the Governing Council has today adjusted the pace of its purchases under its asset purchase program (APP) for the coming months. Monthly net purchases under the APP will amount to 40 billion euros on April, 30 billion in May and 20 billion in June.”

It is curious why the PPA, an instrument to increase inflation, was stimulated when inflation was high and rising. It was on June 9, 2022, that the Board of Governors finally decided to end its APP program.

To fight inflation, the ECB granted negative rates to banks until June 23, 2022. The best possible rate on the TLTRO 3 (targeted long-term refinancing operations for banks) was -1%. The total outstanding amount is 2.263 billion euros. This best negative rate represents a huge subsidy to the banks and an excess of liquidity and therefore inflation, while the banks at the same time were raising the rates on home loans to households from February 2022.

Why did this happen? One of the reasons for the increase in real estate loans is that the ECB could be tempted, like the US Federal Reserve, to raise its rate soon.

The banks do not like a period of uncertainty and have been pushed to raise their rates to individuals. The ECB should have acted differently given the information available at the end of 2021 and avoided an acceleration of inflation beyond 2%. It should have raised its rates like the Fed did in March 2022 and avoided European countries budgeting for inflation with subsidies and creating colossal deficits.

We can expect a slow recession and lasting inflation. The ECB's mistakes will once again be paid for in cash in Europe.

For those who did not understand why we should have worried about this high inflation before, let's remember what Karl Otto Pöhl, a former head of the German Central Bank, once said:

“Inflation is like toothpaste. Once it's out, you can hardly get it back in again. So the best thing is not to squeeze too hard on the tube.”

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