The sharp escalation in military rhetoric between Russia, Ukraine and Ukraine’s allies in the West has led some in the market to wonder whether the tightening of central bank monetary policy could be delayed as a result. But this seems highly unlikely, and would be the wrong move in any case.
The unfolding crisis is growing more worrying by the hour. At the time of publication, Russia had reportedly moved troops into the Donbas region of Ukraine, where forces loyal to Kyiv have been fighting separatists since 2014. In response, Germany had said it would not approve the Nord Stream 2 gas pipeline. The situation is developing so quickly that there will no doubt be multiple major progressions by the time this article has been read. The stakes are high.
Amid the uncertainty, there is growing expectation in some parts of the market, particularly among rates analysts, that the European Central Bank will delay its plans to tighten monetary policy. The ECB is due to end net purchases under its Pandemic Emergency Purchase Programme at the end of March, its Asset Purchase Programme in the summer, and to start raising rates as soon as September.
The broad argument made by the analysts is that Europe’s economy, already battered by the coronavirus pandemic, is too fragile to weather a potential war and tighter monetary conditions at the same time.
But this argument is flawed and should push the ECB off course.
For one thing, a war involving Russia is likely to send already elevated energy prices even higher — especially if the operational launch of Nord Stream 2 is scuppered — adding further fuel to eurozone inflation and hence giving the ECB more reason to raise rates than to bring them down.
Steady as she goes
Meanwhile, the ECB has spent months signalling to the market, through press conferences and in interviews given by individual board members, that tightening is coming.
Public sector and corporate issuers have already digested this and arranged their funding plans around it. A knee jerk reaction to a rapidly evolving geopolitical situation would upend markets, not bring stablity.
ECB president Christine Lagarde raised eyebrows at the beginning of this month with comments that did not seem to reflect reality, saying in a February 3 press conference that spreads had “not widened in any significant manner”. At the time, the 10 year BTP-Bund spread was at its highest level in more than a year.
Such a perceived slip has the power to chip away at the credibility of the word of the central banker, such an essential component of modern monetary policy — almost as important as the ability to set rates and raw printing of money. This is why central bankers usually weigh their words so carefully.
But it was, after all, a minor slip. It is much more important to the ECB's credibility that it pushes ahead with its tightening plan, based on hard data, to counter inflationary pressure.
Lagarde was on more solid ground in the same press conference when she said the ECB was not there to "rock the boat".
Indeed, now is the time to steady the ship and hold the course.