Fed and ECB before decisions: central banks are caught in the Omikron trap

Fed and ECB before decisions
Central banks are caught in the omicron trap

Inflation is picking up, pressure is growing on the US Federal Reserve and the ECB to tighten monetary policy. But a hasty rate hike is risky. It could nip in the bud the economic recovery that was already endangered by the omicron wave.

2022 could be the year in which monetary policy takes a new course. Tonight the US Federal Reserve (Fed) and tomorrow the European Central Bank (ECB) will advise on their next steps. You are facing a challenge: The pandemic threatens to return in new strength with the Omikron variant, which is why the economy needs cheap money at low interest rates. However, it is precisely this low interest rate policy that is fueling the recent sharp rise in inflation rates.

The central banks have to weigh up their announcements carefully: If the impression arises that they are ending their loose monetary policy early, this could slow down the economic upturn. However, the longer they wait to make the announcement, the more difficult it will be to get the high inflation rates back under control.

The US economy is out of recession, but employment has still not reached pre-pandemic levels. The Corona variant Omikron could now exacerbate the supply chain problems again. On the other hand, central bankers are also increasingly concerned about inflation – it reached a 40-year high in the US in November at 6.8 percent year-on-year.

As a first measure, the markets expect the Fed to withdraw from its generous bond purchases more quickly. The central bank had already announced in November that it would slow down the rhythm of purchases: from the current amount of 120 billion dollars (around 106 billion euros) per month, purchases are to be reduced by 15 billion dollars each month and will expire in mid-June 2022. A gradual increase in key interest rates from 2022 would also be conceivable.

Fed decision could put the ECB under pressure

This operation to shut down bond purchases, known in technical jargon as tapering, marks a turnaround in monetary policy that has already sparked speculation on the financial markets about an interest rate hike in the next year. For today’s decision, one thing is certain: the key interest rate, which is in the extremely low range between 0.0 and 0.25 percent, will not yet be touched.

A premature rate hike could be “a political mistake,” warns Oxford Economics chief economist Kathy Bostjancic. There is a risk that this will slow down economic growth. If the Fed suggests a rate hike in 2022, the pressure on the ECB will also increase – so far, the European central bankers in the ECB Council have been very reluctant to make a specific statement about the timetable for normalizing their monetary policy.

The ECB and Fed also disagree on the assessment of current inflation rates: While Fed President Jerome Powell recently recognized that these can no longer be described as “provisional”, ECB President Christine Lagarde sees it differently. Lagarde recently expressed its conviction that inflation will decline in 2022, especially if energy prices fall again. In the euro zone, too, inflation climbed 4.9 percent year-on-year in November to its highest level in 30 years. The argument of temporary inflation, however, is becoming increasingly less credible.

APP instead of PEPP

In the eurozone, too, the Omikron variant could put a spanner in the works of all those who hope to get out of the ECB’s extensive bond purchase program earlier. Those responsible at the ECB repeatedly emphasized that the bond purchases as part of the PEPP program would, as announced, be discontinued in the second quarter of 2022. The ECB is currently buying bonds worth 80 billion euros every month, the total volume of the Corona emergency program is 1.85 trillion euros.

One option for the ECB would be to extend and expand the original bond purchase program APP, which currently buys around EUR 20 billion in bonds every month. According to analysts, such an announcement is not expected until the next ECB Council meeting in early February 2022.

A rate hike in the euro area in 2022 is “very unlikely”, Lagarde stressed again and again. The ING analyst Carsten Brzeski nonetheless expects the ECB to “follow” the Fed with all due caution and then enter a new phase as well: the phase of massive financial support will be followed by a phase of risk management.

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