The devilish monetary dilemma

After the new rise in interest rates decided by the European Central Bank (ECB) —0.25%, in line with what was anticipated— we are approaching the threshold above which the risks inherent to the monetary weapon intensify. As was the case in the period before the great recession, the impact of the adjustments seems innocuous in the early phases of the tightening cycle, but they accelerate later with the appearance of an episode of financial instability. Of course, those responsible for monetary policy are aware of this “non-linearity”, although in the case of the ECB the quasi-exclusive objective of eliminating inflation in the short term complicates the task.

The main argument put forward to support the turn of the screw is that inflation is persistent: despite lower energy prices, core inflation is still at too high levels. On the other hand, the European economy —and especially the Spanish one— is performing better than expected despite the rise in interest rates, with a brief but positive growth of 0.1% in the first quarter. The extraordinary resistance of the labor market acts as a containment dam against the loss of purchasing power while at the same time mitigating the risk of default of indebted households. In any case, private debt levels are much lower than those observed before the great recession. In Spain, households have managed to reduce their liabilities by more than a third, in relation to their disposable income. In the case of non-financial companies, the cut reaches 40%, the result of a deleveraging process that has not concluded.

According to this vision, the cascade of failures of regional banks in the US and the collapse of Credit Suisse in Europe are interpreted as one-off episodes, unlikely under the regulatory umbrella that prevails in the euro zone and with a limited impact given the pull of the economy. Although the hawks have agreed to relax the rate of interest rate adjustment, they have also obtained an important decision for Spain: the end from the summer of the reinvestment by the ECB of all government bonds that come to maturity. This is similar to an order addressed to the States, so that they lend their shoulders in the fight against inflation, correcting their budgetary imbalances. As of July, all the debt amortized at the central bank will have to be placed on the market, in addition to the financing needs already anticipated according to the deficit and the maturities of securities in the hands of the private sector.

Faced with this scenario of reducing inflation with a soft landing for the economy, there is another less friendly one. In the first place, the resilience of the economy is largely based on the phenomenon of stored savings, a factor that is losing strength in light of the fall in household consumption registered in the last two quarters. The trend is similar in the euro area, according to the bad retail sales data (-1.2% in March). Wages continue to lose purchasing power, while financial costs skyrocket. On the other hand, past experience shows that inflation responds late to monetary tightening, so it is not easy for the ECB to calibrate its policy. It can be passed if the underlying trend is already consistent with a convergence towards the objective.

Regarding the immunity of the European financial system, the supervisor himself recognizes vulnerabilities such as the possible connections between the entities that operate under its regulations and shadow banking. Another focus of attention concerns the latent losses generated by the depreciation of assets acquired at a fixed rate. All this without taking into account the impact of eventual isolated outbreaks of financial stress. Achieving both a rapid return to price stability and sustained growth is a devilish dilemma.

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