By Wei Hongxu*
As the European bond market falls, European Central Bank (ECB) President Christine Lagarde said on June 28 that the central bank would launch a bond-buying program on Friday to stem possible debt crises. . The ECB plans to maintain “flexibility” in its reinvestment allocation to its massive €1.7 trillion bond-buying portfolio while launching a new program to stabilize markets. He’s also working on a new bond-buying tool to deal with so-called “fragmentation.” Lagarde said the tool would allow rates to rise “as much as needed” to complete stabilizing inflation at the 2% target. The ECB’s position as a “buyer of last resort” has somewhat facilitated the sale of European bonds and the yields on sovereign bonds of certain highly indebted countries have fallen.
As part of the ECB’s decision to raise interest rates in July to counter inflation, its proposed bond-buying program, while mitigating a possible bond market crisis, effectively contradicts its monetary tightening imminent. The ANBOUND researchers pointed out that, like those implemented by the Federal Reserve and the Bank of Japan (BOJ), the ECB’s monetary policy also faces challenges ahead. With high global inflation shrinking the monetary policy space, the dilemma between inflation and employment is becoming increasingly common. This is not good news for the global economy and capital markets, as the contradiction between economic growth and inflation will plague major central banks for a long time.
Lagarde said the ECB would remain “flexible” on the reinvestment of the PEPP portfolio scheduled for July 1. “We will ensure that the orderly transmission of our policy across the eurozone is preserved,” she said. “We will address any obstacles that could pose a threat to our price stability mandate.”
The ECB’s insistence on playing the role of “buyer of last resort” actually learned lessons from the European sovereign debt crisis triggered by the 2008 financial crisis. ECB at the time and its reluctance to promote easing, the economies and financial systems of highly indebted countries such as Greece, Italy and Spain suffered huge losses as a result of the debt crisis . The ECB finally launched quantitative easing in 2014 to deal with the dual threat of deflation and sovereign debt crisis at that time, which stabilized the economic and financial systems of the countries concerned. In total, the ECB is currently buying more than 49 trillion euros in bonds, which is equivalent to more than a third of eurozone GDP. Over the past two years, the ECB has bought more bonds than all the additional bonds issued by the eurozone’s 19 national governments, giving it huge leverage over the region’s borrowing costs.
As the European market is about to say goodbye to negative interest rates, after the ECB starts raising interest rates, rising borrowing costs will inevitably bring new risk factors to its bond market. The consequences of rising interest rates will not only lead to the economic growth of various countries facing a decline, but they are also likely to lead to a new round of defaults. This is the price the central bank must pay for its measures against inflation. However, as with the Fed, market investors are equally skeptical about the effectiveness of the ECB’s tightening policy in fighting inflation. Currently, the level of inflation in the Eurozone has reached over 8%, more than four times the ECB’s 2% target. The latest CPI data for the Eurozone in June is expected to hit a record high of 8.5%. High inflation is not only the energy distortion caused by the Russia-Ukraine conflict, but also the supply chain adjustment constraints.
These factors mean that the level of inflation will be difficult to contain in the short term and will come down quickly. ECB chief economist Philip Lane said the central bank needed to remain vigilant in the coming months as inflation could continue to climb and the region’s economy could slow due to consumption. Meanwhile, Morgan Stanley said the euro zone economy is expected to slide into a mild recession in the fourth quarter of this year as measures of consumer and business confidence tumble due to lower l energy supply in Russia, while inflation remains high. The eurozone economy is expected to contract for two quarters before returning to growth in the second quarter of next year, driven by rising investment. Despite the risks of an economic slowdown, the ECB is still expected to raise rates at every meeting until the end of the year, culminating in a rise to 0.75% in December, given the persistence of high inflation. However, if the economic outlook deteriorates significantly, the ECB could stop raising interest rates after September. This actually shows that the central bank does not have many effective means in the face of high inflation. It can only take the step-by-step approach and adjust between inflation and recession.
Such a situation also occurs in the United States and Japan. The Fed also faces the conflicting choice of inflation and recession, while the BOJ has to consider a range of effects from changing its easing policy. The situation in Japan is somewhat similar to that of the ECB in that it is difficult for the central bank to tighten its currency by reducing its balance sheet. After the Japanese yen continued to depreciate, the level of inflation exceeded the 2% target for a range, putting the BOJ in a difficult position. If the easing policy advocated by Abenomics is stopped to deal with inflation, it will lead to a rise in the yield of Japanese government bonds, in addition to the bursting of the Japanese stock market bubble. As Japan as a whole faces an unprecedented level of debt, it is not optimistic that Japanese companies can afford the increase in interest rates. At the same time, the BOJ has accumulated a large number of sovereign bonds and risky assets. Once the balance sheet is reduced and sold, it will intensify the sale in the capital market, thus causing a crisis in the capital market affecting both stocks and debts. This crisis, especially the debt crisis, will cause a fatal shock and impact on the economy.
This prospect is also the reason why the ECB is still struggling to stop bond purchases even though it is determined to raise interest rates. Relatively, due to the US dollar’s special role in international currency, the Fed does not take on more risk when it raises interest rates while shrinking its balance sheet, and instead is in a relatively active position. However, the Fed also faces the risk of a recession caused by accelerated policy tightening. This is similar to the situation of the ECB and the BOJ. Balancing inflation and economic stagnation would be the main challenge facing major economies, and it is also a dilemma facing the world’s major central banks.
Conclusion of the final analysis:
Given the high level of global inflation, the world’s major central banks tend to adopt tightening policies. However, the contradiction between inflation and economic growth, and the resulting debt problem, are becoming increasingly important. In these contradictions, central banks typically face the dilemma that as the monetary policy space shrinks, the political difficulty has increased. It also means that these central banks are in the embarrassing position of monetary policy failure and the global economy faces the threat of stagflation for a long time.