Draghi or Trichet?

• Enguerrand Artaz
  Strategist
  La Financière de l’Échiquier (LFDE)

The highly pertinent conclusions of his report on competitiveness, published in September 2024, have so far had little impact, with the European institutions once again conspicuous by their inaction. As for the pragmatism and proactive approach that characterised his tenure at the helm of the European Central Bank, they appear to have been nothing more than a brief interlude, given the dogmatism that reigns in Frankfurt today. Focused on the rise in energy prices caused by the war in Iran, the ECB seems determined to repeat, with great diligence, the mistakes of Jean-Claude Trichet, rather than building on the groundwork laid by his successor.

Just this week, whilst the PMI surveys for May point to a bleak outlook for economic activity in the eurozone, Olli Rehn, Governor of the Bank of Finland and an influential member of the Governing Council, did not hesitate to state that the ECB would certainly be forced to raise interest rates to “preserve its credibility”. In other words, to avoid repeating the mistake of 2022 –  the central bank had admittedly reacted too late to the rise in inflation –  the ECB is prepared to repeat the mistakes of 2008 and 2011, when it raised rates in the midst of an economic slowdown, with the rise in oil prices as virtually the sole justification. These were far more damaging mistakes that triggered or exacerbated the recession, setting Europe on a course for a lost decade in terms of economic growth.

Apart from the ECB’s almost inherent rigour – outside the Draghi years – there is no justification today for taking such a risk. On the one hand, at the risk of stating the obvious, let us recall that the current situation bears no resemblance to that of 2022. The supply shock is not coupled with a demand shock, the labour market is slowing, the starting point for inflation is significantly lower and real interest rates are in positive territory, whereas they were still very negative on the eve of the war in Ukraine (the ECB’s deposit rate was still at -0.5%). The conditions for an inflationary spiral caused by second-round effects of rising energy prices are therefore far from being met. They are all the less likely given the very weak growth in the eurozone in the^firstquarter – just 0.1% – and the outlook for economic activity and consumption.

Furthermore, financial conditions have already tightened significantly in recent weeks. In addition to the ECB’s hawkish rhetoric, the continued rise in long-term rates – with the German 10-year yield having risen well above 3% – and the forthcoming tightening of credit conditions will indeed weigh on economic activity. For businesses, the anticipated tightening, according to the ECB’s latest survey of banks, is close to 2022 levels. It is therefore entirely unnecessary to tighten financial conditions further, especially when the risk of recession appears far greater than the risk of inflation. Admittedly, households’ inflation expectations have risen sharply, but this is typical when petrol prices soar, and even more so in a context where memories of the 2022 inflationary episode remain fresh. Furthermore, market expectations, such as the closely watched 5-year-in-5-years inflation swap, remain fairly stable.

For investors, seeing the ECB sweep aside Mario Draghi’s legacy in this way and fall back into its old ways is not without consequence. The pro-Europe narrative, which buoyed the markets last year and still seemed valid at the start of the year, has now been dented. It will only be further undermined as long as European institutions, led by the ECB, continue to prioritise theoretical dogmatism and regulatory inertia over economic pragmatism and proactive policy. Mario Draghi had, however, attempted to lead the way.

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