Head of the Central Bank of Estonia – POLITICO

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FRANKFURT – Russia’s attack on Ukraine will hurt growth prospects but not the European Central Bank’s efforts to fight inflation, according to a senior central bank official.

Comments from ECB Governing Council member Madis Mueller, speaking to POLITICO this week, suggest rising odds that the ECB will make its first rate hike later this year as it continues to scale back its pandemic policy.

Although the war is likely to leave deeper scars on the eurozone economy than the recent ECB staff projections Proposed at the beginning of March, Müller sees little chance of the central bank extending its bond purchases beyond the third quarter.

“We should be careful not to create additional uncertainty on the markets by appearing to be wavering in our commitment to price stability due to the war in Ukraine,” said Müller. “We do not hesitate in our commitment to price stability, which is our main objective.”

With euro-zone inflation now at 6 percent, the ECB said earlier this month that it would end its bond purchases earlier than previously expected. These purchases will be phased out in the third quarter as long as the inflation outlook continues to permit.

That announcement has prompted some economists to criticize the ECB for moving toward tighter policies while the euro-zone economy is about to take a fresh blow from the war.

But Mueller, who is seen as an ECB hawk, insisted the central bank is unlikely to buy bonds beyond the third quarter.

“For that to change, there should be a dramatic shift in the medium-term inflation outlook,” he said. “Personally, I don’t see a high probability [of that].”

Even if the economic impact of the war will be stronger than the ECB’s latest forecasts – which predicted solid growth of 3.7 percent for this year – “we can still assume that the war in Ukraine will hamper the economic recovery in the euro area will not completely halt,” the head of the Central Bank of Estonia added.

At the same time, Mueller said the ECB may need to revise its inflation forecasts upwards in the short term given rising food and energy prices, and medium-term trends suggest inflation is stabilizing around its 2 percent target.

“It’s important to recognize that we pretty much hit our target, and that’s why it’s important to start normalizing.” [our] monetary policy course,” he said.

As for the timing of the ECB’s first rate hike in more than a decade, everything depends on the incoming data, Mueller said.

“We should not rule out rate hikes in 2022,” he said. “I wouldn’t be surprised if that ended up being the case.” Based on the current outlook, benchmark interest rates will move from zero to positive territory sometime next year, he added.

Müller also maintains that any negative impact on growth from the first rate hikes should be minimal. “Only when we are in positive territory will the impact on the economy become more significant,” he said.

Watch out for the gap

Meanwhile, some economists have expressed growing concern over widening spreads on euro-zone government borrowing costs as a sign that heavily indebted countries may struggle to make payments on government bonds.

Italy’s 10-year spreads over the German reference rate, for example, widened from 100 basis points in October – when investors began betting the ECB would stop buying assets – to around 151 basis points on Wednesday. This spread had peaked at around 170 basis points before the war in Ukraine dampened ECB tightening expectations.

To calm markets, ECB President Christine Lagarde pledged last week that the central bank was ready to “deploy a wide range of tools to counteract fragmentation.” And if needed, it will develop new tools “to secure the transmission of monetary policy as we move down the path of policy normalization,” she said.

For his part, Müller sees no reason for concern. Some widening of spreads is natural when the central bank reduces its purchases in the bond market because it means that the price of government bonds of different countries is increasingly determined by fundamentals, he argued.

“I would be careful not to distort market signals too much by compressing spreads into a very narrow band, regardless of possible changes in risk prospects for different countries,” he said.

And if there’s ever a cause for major concern, he added, “investors can rest easy knowing that the ECB has historically been able to rapidly develop and deploy new policy tools.”

As for Estonia, he acknowledged that after a strong recovery from the pandemic, it would be harder hit by Russia’s war than most member states. But the country has learned its lesson from the past and reduced direct trade ties with Moscow. “In 1998, about 20 percent of total Estonian exports went to our eastern neighbor,” he said. “Now it’s about 4 percent.”

The biggest risks, he said, are higher energy and food prices, and deteriorating consumer and business sentiment. “There is a risk that foreign investors who are further afield would see us as geographically close to Russia [there’s] an increased risk that Estonia could be affected,” he said.

As the Estonian central bank updates its forecasts due later this month, Mueller suggested keeping expectations in check. “We could see a little slowdown in real terms in 2022,” he said, adding that inflation will come down from its 12 percent peak at a slower rate than previously expected.

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