Europe’s Impending Recession Leaves ECB in Deeper Policy Bind

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Europe is bracing for a recession that may do little to tame record inflation, testing the mettle of central bankers who’re just days away from raising interest rates after a decade-long hiatus.

Predictions of an impending downturn are building as the continent’s post-pandemic rebound fades and the reality of a winter energy crisis sinks in — even if fears of a full Russian cutoff don’t come to pass.

That puts the European Central Bank, which announces its rate decision on Thursday, in a tight spot. Unlike in the US, where government stimulus fueled a demand-led surge in consumer prices, inflation in the 19-member euro zone is primarily down to soaring natural gas costs — made worse by the war in Ukraine.

While hefty rate hikes by the Federal Reserve may yet trigger an economic contraction, US price pressures would likely be more in check in the aftermath. In Europe, there’s no guarantee of that as energy is calling the shots.

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The ECB, as a result, has a tougher choice: halt or slow rate increases after already being accused of not acting quickly enough, or push on as households, industry and governments buckle.

“Even if a mild recession hits later this year, inflation pressure is expected to extend well into 2023,” said Aila Mihr, a senior euro-area economist at Danske Bank. “That, of course, sharpens the policy dilemma for the ECB.” 

There’s a 45% chance of a recession in the next year, according to analysts surveyed by Bloomberg this month — up from 30% just a month ago. The likelihood is greater still in Germany, Europe’s top economy, which relies more than most on the Kremlin for gas.

It’s a scenario that must be factored into the ECB’s plans as it kicks off a “sustained” series of rate hikes to tackle inflation that’s shot up to more than four times the 2% target.

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The souring economic backdrop marks a fresh headache for policy makers who took months to commit to raising rates and, once they did so, were forced to speed up work on a tool to soothe potential market jitters as borrowing costs rise.

Even before this week’s planned quarter-point increase — the first since 2011 — markets have pared bets on the scale of the moves to follow. With the Fed delivering hikes of three times that size, the euro has slipped to parity with the dollar for the first time in two decades.

For now, ECB officials are sticking to their guns. Finland’s Olli Rehn said Friday that “it’s still possible to get inflation under control by gradually normalizing monetary policy, without such policy leading to an economic recession.”

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Speaking July 7, Netherlands’ central bank chief Klaas Knot said it’s “very likely” hikes will coincide with weakening economic expansion.

“In an ideal world, you’d want to stimulate the economy but bring inflation down at the same time,” he said. “Unfortunately that’s not what we can do, we have to make a choice. In that case our mandate is very clear: We have to choose bringing inflation down.”

While some economists agree with Knot, others aren’t convinced the ECB can stay the course — particularly as doubts swirl over whether Russia will restart a vital gas pipeline following maintenance. The key will be what sparks any downturn and how deep it turns out to be.

If Russian gas flows resume at a subdued level, the euro area will be “on the edge of recession” in the second half of 2022, with inflation peaking above 10% in September, according to Goldman Sachs.

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In that case, rates would be lifted by 150 basis points this year, it said, warning of much slower hikes if an energy shutoff causes a sharper contraction and faster price growth.

In a mild, “consumer-led” recession triggered by high energy costs, the ECB would pause rate increases in December and February but then continue, according to UBS. A gas cutoff, by contrast, would see it stop after the planned hikes in July and September, its analysts said.

For Carsten Brzeski, an economist at ING who predicts the euro-area economy will contract with or without a Russian energy shutoff, the ECB is generally more likely to be sensitive to growth even if prices remain high. 

“My gut feeling is the ECB would stop trying to fight inflation and let it run a bit,” he said. “We still have problems with government-debt levels, and we need investments, which require cheap financing conditions.”

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Underlining how crucial borrowing costs would become in a severe downturn, Germany has already tacitly agreed to break constitutional debt limits for a fourth straight year if gas is shut off, according to people familiar with the matter. Weaker economies like Italy risk particularly burdensome debt costs.

However any possible recession pans out, it presents another potential obstacle to the long-awaited normalization of monetary policy after years of stimulus to perk up below-target inflation.

The trick will be to determine exactly what dose of rate hikes is appropriate during a downturn to make sure a steeper trajectory for prices doesn’t become entrenched in people’s minds.

“Increased growth sensitivity does not mean that rate normalization will be completely off the table,” Greg Fuzesi, an economist at JPMorgan, said in a report to clients. “The ECB will have to make very difficult judgments.”