Suddenly, inflation is the huge risk that threatens euro zone stability
With painful memories of the 1930s hyperinflation in mind, Germany may be about to pull the plug on the European Central Bank’s policy of loose liquidity
Europe has never had it so good. Economic confidence is brimming over, growth is booming and unemployment is tumbling. Europe looks more united than ever and political populism has gone to ground. European markets are in euphoric mood and optimists are saying it is the start of a golden age of prosperity. What could possibly go wrong?
Plenty could go wrong. Don’t be fooled by any notion everything is hunky dory. Europe has been to hell and back in the last 10 years but it is far from over. The euro zone economy is so propped up by ultra loose monetary policy that the European Central Bank is fast pushing the bounds of credibility. This could all change very suddenly this year and financial markets risk being badly whipped.
Negative interest rates and the glut of quantitative easing money flooding the euro zone were never going to last forever. The ECB’s “special measures” were meant to be a temporary fix and now markets are getting their first wake-up call that change could arrive as soon as 2018. Warning signs are being posted that the days of easy money are over.
Political tensions are building back at ECB headquarters in Frankfurt. Angry whispers are emerging that policy excesses have gone too far and need reining in soon. Germany’s Bundesbank is especially worried that runaway super-stimulus is opening up a can of worms to heightened inflation risks. It contends that inflation has only one way to go and that is up.
The Bundesbank thinks the euro zone economy is strong enough to stand on its own two feet without the need of extra stimulus. Germany’s own economy is on fire. Industry is working overtime, export orders are surging and background wage pressures are picking up. It is time to nip things in the bud before inflation takes root with damaging effect.
The post-war architects of today’s Bundesbank would be turning in their graves at the sight of the ECB’s QE programme. In their view, negative interest rates, colossal debt purchases and explosive money printing would be a recipe for disaster. Germany’s chilling experience of hyperinflation in the 1930s runs so deep in the nation’s psyche it still dominates official thinking today.
German inflation harbingers are already in plain view. House price rises are bubbling in the major cities and early signs of wage pressures are emerging too. Germany’s biggest trade union, IG Metall, is threatening all-out strikes unless employers meet demands for an inflation-busting 6 per cent pay hike this year. It could trigger copycat pay demands across Germany and other euro zone nations.
Maybe Germany could cope with higher wage inflation thanks to its strong productivity record but it would be a disaster waiting to happen across the euro zone if higher pay demands catch on, especially in the low productivity, distressed economies after a decade of enforced austerity. European inflation would return with a vengeance.
Germany believes the ECB is practising footloose and fancy free policies and wants to close it all down as soon as possible. Other less well-off countries, especially in southern and eastern Europe want super-loose policy to extend as long as possible to consolidate stronger recovery. Differences are entrenched and the markets will be stuck in the middle as and when the row turns nasty.
Germany wants low inflation, while a large majority of euro zone members want higher growth and stronger job creation. The sides seem irreconcilable but markets know Germany gets the upper hand in the end as it holds the purse-strings for Europe. It is why the euro has suddenly started to take note and euro zone bond yields have begun to rise. The days of plenty could soon be over.
Just how soon is the key for markets. The US Federal Reserve already has five rate rises under its belt and probably has another four hikes pencilled in for this year. Europe is badly behind the curve and needs to make up for lost time. Two quarter-point ECB hikes could be on the cards before year end.
Europe’s futures markets sniff a potential sea-change with forward contracts already showing some early signs of reactivity. It is not a question of if but when and financial stability is at risk. When the ECB finally sneezes, European financial markets will catch a heavy cold.
David Brown is chief executive of New View Economics