Ukraine risks reignite uncertainty over ECB policy

Ukraine risks reignite uncertainty over ECB policy

Mon 14 Mar 2022

2012 was a year for the financial history books. Europe’s greatest experiment, the common currency area, was moribund after only twelve years of life. The post-Lehman economic convulsions had driven Greece, its weakest economy, bankrupt, and had brought Italy, its most indebted economy, to its knees. Mario Draghi, then Chair of the ECB, and the current Italian Prime Minister, took a leap of faith. He went off-script and, without the permission of the all-powerful Angela Merkel, vowed to “do whatever it takes to save the Euro”. The ECB would go on to ignore European treaties forbidding debt mutualisation and print money to buy sovereign bonds. For markets this radical step towards ultra-loose monetary conditions meant that the ECB was, after three long years, beginning to follow the Fed’s paradigm. Traders, who had already learned not to “fight the Fed”, were not willing to bet against another, equally sized central bank and the crisis was averted. It took another three years to agree on the format but, from that point on, global central banks moved in lockstep.

Whilst the ECB saved the day, it also removed the impetus for real change in the Eurozone. The banking union for the common currency area remains incomplete. Fiscal transfers continue to be forbidden and nations are still restricted by the 3% target deficit which is due to make a comeback in 2022. This means that other countries with more fiscal room will be able to support their economies more effectively in a post-pandemic world.

Approximately four months ago, central banks stopped moving together. The Bank of England and the Fed did an about-turn, abandoning the narrative of transitory inflation and turning hawkish on interest rates. But the ECB did not follow. Are Europeans just delaying? Are they risking runaway inflation? Or are they considering much bigger stakes?

Only a few months into an environment where higher levels of inflation look to be the norm, we are already seeing that it can put significant strain on consumers. Recent history is a good place to observe inflation’s effects in the Western world: you need only look back to the 1970’s and the wage-price spiral that ensued. Larger pay checks were demanded by workers to better protect their families from the rising costs of goods (sound familiar?), only to find that these wage increases were fuelling further price inflation.

However, European labour markets are notoriously inflexible: failing to match the earnings mobility and higher salaries available across the pond. The record unemployment and strong rebound in labour force participation in Europe has not been accompanied by the robust rise in average earnings that the US is currently experiencing. Whilst demand for skilled workers is at a record high in the EU, the impact on European society has not been proportionate, benefitting highly skilled workers with larger salaries more significantly than middle-class consumers, who continue to face wage growth stagnation1,2. In conjunction with inefficiently run businesses that are inherited through generations3, this has resulted in lack of consumer spending power and helped to prevent inflation from reaching levels recorded in the US. Ultimately, it seems that ECB can afford to worry less about reliving an era filled with disco music and extra-large collars on shirts due to demand-pull inflation, for the time being.

Nevertheless, it is evident that inflation is still fuelling price rises across Europe. Much of the inflation that we are currently experiencing across the developed world was initiated by supply-chains bottlenecks as the all-but forgotten Omicron variant swept across the globe and kept people away from work. Pressures on supply chains had only just began to ease in Europe when Russia began to amass troops at the Ukrainian border. Whilst we are yet to see the full impact of the invasion of Ukraine on European economies, conflict on European soil will, in all likeliness, encourage further disruptions to an already fractured European supply chain network. Combined with Europe’s dependence on Russia for non-renewable energy resources and skyrocketing commodity prices, the stage is set for a severe bout of cost-push inflation in the Eurozone.

Even though the sole mandate of the ECB is to manage inflation within the Euro area, traditional attempts to intervene are likely to be fundamentally flawed. The European debt crisis rocked the continent’s economic stability and is anything but a distant memory. Over a decade later, Italy continues to face a severe debt problem, with net public debt estimated to be around 150% of GDP in 2021. Whilst interest rates remain low, these astronomical levels of debt remain controllable and relatively affordable. However, aggressive interest rate hiking would spell trouble for Italy and other European countries with substantial debt loads, making it significantly harder to pay these debts back.

The cold reality is that the ECB has little other choice but to wait for other central banks to take on global inflation. Restricting monetary supply in the US will have an impact on demand and growth. It could even, in extremis, lead to a recession. Nevertheless, Massachusetts and California will, in all probability, remain part of the Union. Restricting monetary supply for indebted common currency nations could have devastating consequences for the Eurozone and the European Union. Therein lies the risk for investors and portfolio managers: not just that a wrong policy decision could trigger a 2012-like crisis, but that the ECB has few tools at its disposal to combat inflation without severe repercussions. Despite the recent, unexpected adoption of a more hawkish rhetoric, they have little room to manoeuvre if push comes to shove.

Whilst the Fed’s independence may soon be challenged if it fails to get ahead of inflation, for the ECB, its fundamental mandate of controlling inflation is at risk. Prolonged price escalations could result in Eurozone nations agreeing to give a mandate to the bank to support the Euro at all costs, or the failure of the ECB to tackle inflation could lead to challenges by constitutional courts across the continent, with unforeseen consequences. The risk of a Eurozone blowout has always been a slow-moving train. In some sense, like the Russian invasion of Ukraine. Nevertheless, every day the ECB fails to convince its members that it can adhere to its one and only written mandate, tackling inflation, is a day that brings the Eurozone risk closer to materialisation.


  1. Manyika, J., Madgavkar, A., Tacke, T., Woetzel, J., Smit, S., & Abdulaal, A. (2020). The social contract in the 21st century. McKinsey Global Institute.
  2. Smit, S., Tacke, T., Manyika, Lund, S., & Thiel, L. (2020). The future of work in Europe. McKinsey Global Institute.
  3. Freund, C., & Oliver, S. (2016). The Origins of the Superrich: The Billionaire. PIIE – Working Paper 16-1.