The euro area can no longer avoid a return to budgetary discipline

Faced with the double explosion of inflation and inflationary expectations in a context of severe labor market tensions, the US central bank (the Fed) unveiled its program to calm the overheating economy last week. The program is developed in two parts. A steady rise in interest rates at least to neutrality, which began in March, and a central bank balance sheet contraction which is expected to begin in June.

The rise in the key rate, which is a short-term rate, is unlikely to have a strong effect on inflation. On the other hand, the contraction of the monetary base could cause a rapid rise in 10-year rates, which would hold back the demand for investments. As of March 2022, the Fed’s balance sheet was $ 8.96 trillion, nine times the amount before the surcharges crisis (2007). According to the latest indications, the Fed is preparing to reduce it by reducing its stock of government bonds by 65 billion per month since June and its stock of private mortgage-backed bonds by 35 billion per month. This reduction is expected to occur primarily by “natural decline”, as these bonds mature, but also by selling bonds as needed to meet its monthly target. Just as buying bonds raises their price and lowers yields, stopping these purchases instead causes prices to drop and yields to rise.

No reduction in the ECB’s balance sheet for the moment

While euro-zone countries did not commit the same excesses as the United States in terms of fiscal stimulus during the Covid-19 crisis, inflation rose rapidly to reach 7.5% in March, well above the 2% target of the ECB (European Central Bank). . In 2022, the war in Ukraine and the increase in energy prices should add 2 percentage points to the inflation already present according to the second OECD. To address this drift, Christine Lagarde, its president, announced in September the end of net asset purchases by the ECB, but without considering a possible reduction of the ECB bill which reached 8,700 billion euros at the end of March, compared to 1,507 billion euros at the end of 2007. For the moment, the ECB intends to keep the balance constant, at least until the end of 2024.

The ECB’s timid reaction to the Fed is not surprising given the difficulty of determining the appropriate monetary policy for the 19 eurozone countries that do not have the same economic structures, do not share the same analysis of the situation, nor the same culture in terms of monetary policy. High inflation, provided it is short-lived, would allow the public debt to be partially eroded (to the detriment of savers) and above all would allow a more fluid realignment of wages within companies and between sectors of activity. On the other hand, persisting high inflation is incompatible with the single currency project.

We are currently seeing a rapid rise in 10-year interest rates in the US and Europe. The interest rate on German bonds, which had remained negative until January 2022, stood at 0.71% on 8 April. 10-year rates in southern countries are much higher (2.40% for Italy on 8 April, 1.74% for Spain). This increase in the risk premium on these securities derives directly from the ECB’s future inability to continue to support budget excesses as it was able to do during the Covid-19 crisis, when it absorbed almost all of the new euro area debt. Future deficits and renewal of debts will therefore have to be financed at ever higher interest rates. It is true that as long as interest rates do not exceed the nominal GDP growth rate, debt sustainability should not be a problem, as the debt ratio tends to stabilize. But nothing guarantees compliance with this condition for countries with a fragile budget situation, as in the case of the seven countries of the euro zone whose debt exceeds 100% of GDP. For these countries, the emergence of default risk premia is highly likely to push interest rates above nominal growth. Spain and Italy in 2012 were saved in extremis by a restructuring of their debts by the program Monetary transaction on securities (OMT) set up urgently by Mario Draghi. This program authorizes the ECB to buy bonds from countries in financial distress, which limits or even eliminates default risk premiums. Today, this program is largely undermined by the resumption of inflation. Indeed, the ECB is unlikely to be able to authorize a massive bond purchase in a time of high inflation. The return of inflation therefore means the return of risk premiums.

The “whatever it takes” is over

Inflation, with the rise in interest rates and the exclusion of quantitative easing (asset purchase program) and the MTO, therefore leaves no alternative to governments. The easy money is over, “whatever it takes” is over and hopefully the Covid-19 crisis is over. Balanced budgets will have to be recovered from all countries in the short term, either through a reduction in spending, or through an increase in tax revenues, or an appropriate combination of the two.

Furthermore, a restrictive fiscal policy would be appropriate to support the ECB in its fight against inflation. If demand slows due to reduced government spending or increased taxes, inflation will be contained without requiring large increases in interest rates. Tax policy has the advantage of being defined at the national level by each country according to its redistributive and social culture. For the moment, Joe Biden has not yet officially abandoned his colossal stimulus plans. It’s a safe bet that the latest unemployment data, 3.6% in March, near the pre-covid level of 3.5% in February 2020, testifying to an overheating economy, should put the last nail in the coffin. of the budgetary ambitions of the American president.