The ECB’s Policy Mix Lacks Coherence 

At its press conference last Thursday, April 30, the European Central Bank decided not to raise interest rates, at least for now. There were two main reasons for this.

The first is that the rise in inflation to 3 per cent is mainly due to higher energy prices, which have not yet been passed through to other goods and services. There are still no visible “second-round effects” that could trigger an inflationary spiral.

However, the longer the conflict lasts, and the higher oil and gas prices remain in the coming months, the greater the risk that such a spiral will materialise. At that point, an increase in interest rates would become unavoidable.

The second reason is that, even without an increase in interest rates, financial conditions have already become restrictive, especially for European companies.

This is due to several factors, some of which are also linked to the actions of the central bank.

The first concerns the sharp rise in long-term interest rates triggered by the war in Iran. This increase reflects financial markets’ expectation that the ECB will raise interest rates at least two or three times in the coming months.

Investors are operating on the assumption that the ECB does not want to repeat the mistake of 2022, when it was late in tightening monetary conditions and allowed inflation to get out of hand.

So far, the ECB has failed to push back against these expectations. In practice, that means it has validated them.

The second factor concerns the ECB’s decision not to halt the policy it began three years ago of not reinvesting maturing government bonds — the so-called quantitative tightening — unlike the US Federal Reserve and the Bank of England, which have recently adjusted course in response to high financial-market volatility.

This contributes to pushing long-term rates further up just as they are coming under renewed pressure, and it reduces the liquidity available in the market.

The ECB’s justification is that liquidity conditions remain favourable and that, in any case, the size of its balance sheet must be reduced.

Europe’s banking system, however, is deeply concerned not only about the speed of the liquidity contraction, but also about the prospect that it will have to refinance itself at higher rates, which will then be passed on to customers. This will have restrictive effects on the real economy.

The third factor concerns the banking system’s willingness to extend credit. The latest bank lending survey, published a few days ago, shows a greater-than-expected tightening of credit conditions, along with expectations of a further deterioration in the next quarter. In other words, there is a risk of a credit crunch.

What the central bank does not acknowledge is that the main cause of this deterioration lies in the prudential measures implemented by its own supervisory arm.

The survey shows that among the main factors pushing banks to lend less are tighter regulatory requirements and pressure on banks to take fewer risks. These pressures mainly take the form of moral suasion, as well as warnings of higher capital requirements or even sanctions in cases where lending is deemed excessive.

The constant insistence on the need to strengthen capital buffers against any new potential risk, like geopolitical risk, to achieve so-called “forward looking resilience” aims at pushing banks to accumulate excess capital. The complexity of approval procedures for share buybacks creates a further incentive for banks to cut back on lending.

In short, while the central bank is pursuing a prudent monetary policy in response to the energy shock, it is at the same time adopting prudential and liquidity measures that tighten credit conditions for the real economy.

Greater consistency would be useful.

A previous version of this article was published in the Italian daily Il Foglio