Capital Ideas^TM

So far in 2022, the European economy has held up remarkably well despite investor worries about a war-induced recession. But as the European Central Bank (ECB) prepares to hike interest rates at its 21 July meeting, the economy faces substantial challenges.

The ECB is dealing with a similar scenario to the US Federal Reserve and the Bank of England, which are both struggling to rein in historically high levels of inflation without triggering a deep recession. The central bank has signalled its intention to increase interest rates at its July and September meetings and confirmed the end of its asset purchase programme.

There’s also evidence that inflation expectations among consumers and companies have changed and started to drift upwards. Given that real policy rates remain exceptionally low and inflation risks are increasing in Europe, the ECB will likely be eager to keep tightening until there is definitive evidence of a clear downtrend in consumer price index (CPI) inflation.

However, while robust consumption and services growth have powered the economy even as manufacturing has weakened to date, I see three major risks looming on the horizon that could make a soft landing difficult to achieve: a disruption to the continent’s gas supply from Russia; persistent, widespread inflation; and widening bond spreads (difference in yields) among European Union (EU) member states.

What can happen if Russian gas is cut off?

The threat of disruption to Europe’s energy supply from Russia has become very real over the past few weeks. Energy prices have already started to rise after a limited reduction in imports from Russia. And Berlin is clearly preparing for Russia to cut the gas off completely, which would then necessitate demand-rationing in Germany and other countries, like Italy.

If the flow of Russian energy is halted, it will add to inflation and put downward pressure on economic growth that could result in the biggest stagflationary shock since the mid-1970s.

Such a scenario would cause an acute dilemma for the ECB. If this were just about economic activity and an energy supply disruption creating a recession, it would suggest the ECB should be cutting interest rates. The problem is that if Russian gas is cut off, inflation will likely go even higher, possibly into double digits, which would indicate the ECB ought to keep tightening monetary policy.

It's worth bearing in mind that the one central bank that enhanced its reputation in the 1970s was the German Bundesbank, because it did not accommodate a supply shock inflation. It actually raised interest rates to squeeze out inflation. And I think German authorities will be under extreme pressure to do something similar this time. It might sound economically unwise to raise rates when an economy is experiencing recessionary pressures, but I think not doing so could create significant strains within the eurozone and within the ECB.

It is challenging to model the shock that would be caused by a halt to Russian energy imports, as the impact would feed through many channels: prices, volumes and uncertainty across all sectors of the economy. Moreover, macroeconomic models are estimated with historical data, which makes it hard to calibrate them for unprecedented scenarios. Nevertheless, estimates from Germany’s five economic research institutes and the ECB’s staff show that a complete cutoff of Russian energy imports would represent a huge and persistent negative supply shock to the European economy.

 

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