ECB President Lagarde said that the sharp rise in inflation, to 7.5% in March 2022, was largely the result of the 45% rise in energy prices over the past year. 

While many other central banks up the ante on monetary tightening, the ECB is left to try to find a halfway house between tightening enough to keep inflation at bay, but avoiding the overtightening that could see the economy tumble into a recession. Mr. Steve Barrow, Head of Standard Bank G10 Strategy, thinks it is going to be incredibly challenging to do this and it seems more likely that the ECB will fail.

At last week’s ECB press conference, ECB President Lagarde said that the sharp rise in inflation, to 7.5% in March 2022, was largely the result of the 45% rise in energy prices over the past year. That’s undoubtedly true. Some 4.9 percentage points of that 7.5% annual CPI rise is down to energy.

In the past, when energy prices have spiked in this way, the ECB has "looked through" the surge in prices, focused on core (non-food and energy) prices, and, very often left policy unchanged as a result. But this is different in a number of respects.

The first is the scale of the increase in energy price inflation, which is far bigger than before.

The second is that it has contributed to a significant increase in market-based inflation expectations, which have reached decade highs (if we use the five-year forward-starting inflation swap).

A third factor is that while energy prices have surged, in part due to the conflict in Ukraine, there is a longer-term structural move away from fossil fuels and a concern that the resultant underinvestment in fossil fuels will keep prices very elevated as they are slowly phased out. In short, we can’t be sure whether the surge in energy prices is short-lived.

A fourth factor is that core prices have also moved sharply higher, to 3% in March; far higher than the levels we’ve seen in the past when energy prices have pulled up the total CPI. So, while we can’t deny that inflation in the euro zone is much higher due to energy prices, there’s still sufficient core inflationary pressure to suggest that the ECB cannot afford to "look through" the current surge in headline inflation.

And, of course, the ECB tells us that it is not going to look through it. Instead, it will likely lift policy rates, with the market betting that this will start in the second half of the year. But the 60-bps, or so, of tightening priced into the euro curve this year is still a long way from the 144-bps for the UK curve and even further away from the 210-bps priced for the Fed. This is despite the fact that price pressures seem to be just as entrenched in the euro zone as they are in the UK or US. What is different, at least with the US, is the recession risk given the proximity of the Russia/Ukraine conflict and the high dependency of the EU on Russian energy. This is making the ECB more cautious.

So, while the Fed looks as if it will be going hell-for-leather to get rates up quickly, as will most other G10 central banks, the ECB will hang back. But the problem here is that the ECB risks falling between two stalls: neither tightening sufficiently if inflation rather than recession is the greatest threat, nor keeping financial conditions sufficiently loose should recession be the greater threat than inflation. The ECB probably needs to decide which is the biggest threat and aim its policy at that rather than trying to cover both bases.

Other central banks have clearly decided that inflation is the greater risk, but, despite its inflation mandate, we are not convinced that the ECB has decided to do the same. "If we are right about this, inflation is likely to remain a protracted problem, and that’s difficult for debt-laden economies, like Italy, which will see debt servicing costs rise. The problem here is that it could spiral into a new version of the euro zone debt crisis that we saw back in 2010-12. In short, the ECB faces an incredibly difficult test and it is one that we think it is likely to fail", Mr. Steve Barrow said.