Christine Lagarde’s impossible mission

Christine Lagarde’s European Central Bank (ECB) has not one but two missions — an official mission to keep inflation at no more than 2 percent, and an unofficial mission to prevent the euro from falling apart by keeping the eurozone’s highly indebted countries like Italy afloat.

By having sent energy and food prices through the roof and by increasing the risk of another European economic recession, Russia’s invasion of Ukraine highly complicates the ECB’s simultaneous attainment of its two missions. This likely will keep the euro on the back foot in the period immediately ahead.

Even before the Russian invasion, the eurozone had a serious inflation problem as a result of COVID-19-related supply side shocks combined with the ECB’s extraordinarily easy monetary policy stance. Over the past year, consumer price inflation rose to a record 5.8 percent, which was almost three times the ECB’s inflation target. It did so at a time when the ECB maintained a negative interest rate policy and when it was engaged in an unprecedentedly large bond-buying program.

The surge in international energy, food and metal prices in the wake of the Russian invasion is bound to send already high eurozone inflation meaningfully higher. This is particularly the case considering Europe’s high dependence on Russian natural gas imports for its energy needs, as well as the very rapid rate at which Europe’s natural gas prices are increasing. Whereas international oil prices have increased by some 60 percent since the start of this year, European natural gas prices have increased by some threefold.

If sustained, the surge in the eurozone’s energy prices has the potential to push the eurozone economy back into recession. Unlike the United States, which has become energy independent, the eurozone is highly dependent on imports for its energy needs. This means that higher energy prices in Europe effectively constitute a tax on the European consumer, which is not nearly offset by a boost to the European energy sector as is the case in the U.S. 

Even before the eurozone was hit by the Russian energy price shock, Italy, the eurozone’s third-largest economy, had very troubling public finances. During the pandemic, its budget deficit has ballooned and its public debt has skyrocketed to an all-time high. At end-2021, Italy’s public debt-to-GDP ratio was around 155 percent or at its highest level in Italy’s 150-year history. The last thing Italy needs is another economic recession, which would make its public finances even more unsustainable. 

Over the past year, despite its seemingly unsustainable public finances, the Italian government was able to fund itself easily at very low interest rates. This was in no small measure thanks to the ECB’s EUR 1.85 trillion Pandemic Emergency Purchase Program. Under that program, the ECB has purchased EUR 250 billion in Italian government bonds, or the equivalent of the Italian government’s total net borrowing needs.

Russia’s invasion of Ukraine is now highly complicating the ECB’s life, both by adding to inflation and by raising the specter of another European recession that would further compromise Italy’s public finances.

This confronts the ECB with an unpalatable policy choice. The ECB can slam on the monetary policy brakes to get inflation back under control but at the risk of triggering another round of the Italian sovereign debt crisis. Alternatively, it can keep its pedal to the monetary policy metal by expanding its bond-buying program and maintaining negative interest rates. That would keep a highly indebted Italy afloat, but it would do so at the risk of losing control over inflation. 

If past is prologue, the ECB will do whatever it takes to keep the euro from breaking apart. It will do so even if this might involve risking a prolonged period of high inflation and a weakening currency. Since the start of the year, sensing that the ECB would pursue a looser monetary policy than would the Federal Reserve, markets have sent the euro down some 10 percent against the dollar. The Russian invasion is now likely to keep the euro on its back foot for some time to come.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.