Market moves compound risk of European Central Bank's policy error

With the world facing slower growth along with surging consumer prices, the risk of stagflation stalks the global economy. The danger is particularly acute in the euro zone, where national sovereignty has hobbled the fiscal response to both the pandemic and Russia's invasion of Ukraine. And the European Central Bank's newfound hawkishness threatens to provoke a market reaction that outguns official policy by tightening monetary conditions by more than the economy is able to withstand.

Rampant price increases in energy, food and other commodities have been exacerbated by the prospect of the war between Russia and Ukraine further dislocating global supply chains. Bloomberg's News Trends function, which tallies the occurrences of keywords in articles from more than 1,500 sources, illustrates how stagflation is pinging the world's radar.

Growth looks vulnerable. Strategists at JPMorgan Chase & Co. reckon "many" now see a euro-zone recession as likely. The bank's experts disagree, arguing that governments could surprise with more fiscal stimulus than is currently anticipated while earnings in the bloc won't contract and gross domestic product remains above 1%.

That earnings outlook, though, looks shakier by the day. Analysts at Goldman Sachs Group Inc. last week slashed their earnings-per-share outlook for the Euro Stoxx 600 index to 2% this year, down from 8% previously. And an index compiled by Citigroup Inc. of profit revisions for European companies excluding the U.K. has turned negative for the first time in more than a year.

The gloomier economic environment is reflected in the new forecasts unveiled by the ECB last week, with growth downgraded for this year while inflation is expected to accelerate.

But it didn't stop policy makers from hastening the winding down of the region's market support, scaling back bond purchases with a view to ending the program by the third quarter. David Powell at Bloomberg Economics says the move reflects "deep discomfort among hawks on the Governing Council with adding stimulus at a time of record inflation." Government borrowing costs across the bloc have climbed, with the benchmark 10-year German bond yield increasing to its highest level since November 2018.

That market reaction — or overreaction, depending on your view – threatens to tighten the monetary backdrop by way more than the ECB intends, or is comfortable with. Just a year ago, an index of euro-zone financial conditions constructed by Bloomberg Economics was at a record low. The gauge, including measures of price-to-earnings ratios, bond yields, corporate bond spreads and the exchange rate, now shows conditions are at their tightest in two years.

"We cannot be the only central bank not reacting," an unidentified person who attended Thursday's central bank meeting told the Financial Times in the wake of the decision. Fear of missing out, though, is rarely a sensible compass by which to steer policy. By the time of its next meeting on April 14, the ECB may well find itself trying to talk the markets back down again.

— With assistance by Elaine He

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.