This year, the European Central Bank began raising interest rates. In doing so, it has, for the third time in its history, unwisely embarked on a cycle of monetary tightening. The same thing happened in 2001 and 2008. On those occasions, the bank reacted to commodity-driven inflation, tightened policy too early, and was forced to reverse course shortly afterwards. As soon as the initial boost had worn off and growth began to falter, the rate rise proved to be a mistake. The risk is therefore not merely theoretical. This scenario has already played out twice, and yet the bank is walking into it again with its eyes wide open.

The same mistake, energy once more

The trigger is, once again, an energy shock. The crisis surrounding Iran and the Strait of Hormuz drove up energy prices and disrupted supply chains. Such a shock dampens growth whilst temporarily driving up prices. It is precisely in this climate that the ECB is making the wrong choice. Inflation rose from just under 2 per cent to 3 per cent, and part of that seeped through to core inflation, which now stands at around 2.5 per cent. Fearing second-round effects, the bank is downplaying the signs of a slowdown.

The signals the bank is ignoring

These signs are certainly there. Wage growth under collective agreements is continuing to weaken, and the energy shock has not yet led to higher wage demands. The common, persistent component of inflation remains anchored at around 2 per cent. The recent spike is therefore not a broad-based rise in prices. Once the temporary energy effects fade – particularly if oil prices rebound as the situation in the Strait of Hormuz normalises – the underlying pressure looks much weaker than anticipated. Core inflation could fall below 2 per cent. Moreover, China is exporting its way out of its own slump, whilst Europe is absorbing the overcapacity. Import prices for Chinese consumer goods have been negative since early 2023, and the strong euro is amplifying that effect. Taken together, these signals point to a more pronounced slowdown than the official figures suggest.

The contrast with the United States is telling. As a net exporter of oil, the US actually benefits from more expensive energy. Europe has made two wrong choices – first with Russian gas and then with Qatari LNG – and is thus suffering its second bout of stagflation within five years.

A continent heading for recession

And this at a time when the economy is already so vulnerable. Germany is grappling with a simmering energy crisis, a deteriorating competitive position and unfavourable demographics. Industrial production there remains close to cyclical lows, comparable to those seen during the credit crisis and the pandemic. Chancellor Merz’s fiscal offensive is bogged down by institutional inertia, pushing the growth dividend back to 2027 or later. France is grappling with a deficit of around 5 per cent of GDP, the highest tax burden in the OECD, and public debt exceeding 300 per cent of GDP. Thanks to the ECB, a full-blown crisis is likely to be averted, but the brake on growth, profits and valuations persists. Together, these two countries account for half of the eurozone. A technical recession seems inevitable.

This is certainly not the time to raise interest rates. Yet the ECB is doing so, against its better judgement. On two previous occasions, that same reflex cost the bank precious time; the fact that this is happening a third time turns a misstep into a pattern. The donkey and the stone: the ECB is the exception to the proverb.

  
Read the full column in Financial Investigator magazine