Why the ECB’s Next Move Could Either Save or Sink the Eurozone Economy

A small group of people will soon make a decision that will impact about 350 million lives in a building in Frankfurt that is all glass and angles. With its polished floors, security badges, and climate control hum, the European Central Bank’s headquarters exudes the kind of clinical hush you might expect. Beneath that serenity, however, this spring’s calculus has never been messier. Growth is slowing, inflation expectations are rising, and Christine Lagarde and her colleagues must decide which fire to put out first.

One of the issues is that the numbers don’t add up. Consumer expectations for one-year inflation shot up from 2.5 percent in February to 4.0 percent in March, an increase that hardly ever occurs outside of a crisis. At the same time, corporate profit and wage expectations are declining, and banks tightened lending standards more than economists anticipated. The term “stagflation,” which central bankers learn early in their careers and hope to never use again, is set up in textbooks.

Energy is now the wild card due to the war with Iran. The industrial base of the eurozone has been affected by rising oil and gas prices, with Germany being the most severely affected. Factory floors that were already operating at a lower temperature than usual now face additional pressure on profit margins. The atmosphere changes when you stroll through any Bavarian mid-sized industrial town. Orders take longer to process. Talks about hiring are more subdued. Businesses seem to be preparing without fully understanding what they’re preparing for.

For her part, Lagarde has adhered to a meticulous script that is meeting-by-meeting, data-dependent, and does not require prior commitment. It’s fair that central bankers use this kind of language when they truly don’t know yet. However, markets are placing more audacious bets. It appears that investors anticipate a rate increase by the summer, followed by one or two more later in the year. Adverse growth signals will make aggressive hikes more difficult to justify, according to ING’s Carsten Brzeski, who described the situation as a stagflationary shock rather than merely an inflationary one. Most likely, he is correct. This is not a comfortable place to move.

One piece of the puzzle is the euro itself. It has increased by almost 14% against the dollar in the last year, making imports more affordable and exports more difficult. On paper, this is disinflationary, but in reality, it is growth-sapping. The governor of France’s central bank has publicly expressed concern about it. While energy drives up the headline number, some at the ECB obviously worry that the strength of the euro could push inflation undershoot back into the picture. It’s possible that both concerns are present at the same time, which is what keeps members of the Governing Council up at night.

Thin consolation is provided by history. The eurozone has experienced pandemic shutdowns, sovereign debt panics, and credit crises. The ECB found a tool each time. The tools are pointing in different directions this time. You can cushion growth by cutting rates, but you run the risk of allowing expectations to deviate further from the anchor. Raising rates will mitigate the effects of second-round inflation, but it will exacerbate an already precarious slowdown. Watching this play out gives me the impression that half the room will think Lagarde made a mistake no matter which way she goes.

From the outside, what comes next will likely appear modest: a quarter-point move, careful wording, and courteous questions at the press conference. However, the repercussions won’t be minor. Somehow, the credibility of a currency and the recovery of a continent are riding on the same Thursday afternoon.