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The European Central Bank finds itself in a defensive posture, and for this instance, the attributions can be ascribed to Germany

Germany, ostensibly the preeminent force within the club, finds itself grappling with a noxious blend of economic challenges. A weakened trade relationship with its pivotal partner, China, has compounded the predicament.


The European Central Bank is on the back foot again and this time the bad news doesn't come from Greece, Italy or any of the usual suspects in the bloc's poorer south.

uedf ecb

Germany, ostensibly the preeminent force within the club, finds itself grappling with a noxious blend of economic challenges. A weakened trade relationship with its pivotal partner, China, has compounded the predicament. Concurrently, a decline in its expansive manufacturing and construction sectors has inflicted further strain. Additionally, questions of existential import loom over the very foundation of its economic model, premised upon the accessibility of economical fuel from Russia.The repercussions of Germany’s troubles reverberate across the entirety of the euro zone, instigating a profound hindrance to collective growth and casting the ominous shadow of a recession. This dire trajectory stands in stark contrast to the sanguine projection initially envisaged by the European Central Bank (ECB) – that of a gradual descent into a “soft landing,” characterized by measured growth and inflation. Meanwhile, the United States remains cautiously optimistic about its own pursuit of comparable economic outcomes.This unfolding scenario necessitates a recalibration of the ECB’s stance. The once resolute dismissal of a potential pause in the ongoing series of interest rate hikes has yielded to a candid discourse on the subject, with discussions centering on the possibility of implementing such a pause as early as the forthcoming month.

Market sentiment, however, indicates a more pessimistic prognosis. It suggests that the central bank might eventually find itself compelled to retract some of its prior rate increases, a trajectory that bears semblance to its actions during the preceding tightening cycle in 2011. Back then, the escalation of debt crises across nations like Greece, Portugal, Ireland, Spain, and Cyprus, coupled with a broader recession, necessitated a similar response.

There are noteworthy parallels between the circumstances of 2011 and the current milieu," remarks Richard Portes, an esteemed economics professor at the London Business School. "A significant supply shock was witnessed, with indications of transient inflation."


Unlike then, Germany rather than the south of Europe is at the epicentre of the problem, bringing many commentators to dust off the “sick man of Europe” moniker last used to refer to that country in the early years of the new century.

It’s not without irony that the expression should have been coined by Emperor Nicholas I of Russia to describe the Ottoman Empire in the 19th century.

Some of Germany’s present misfortunes also originate in Russia, on which Berlin had relied for a third of its energy supply until the invasion of Ukraine jeopardised those cheap imports.


Others run deeper and are home brewed, relating to its over-reliance on exports, lack of investment and shortage of labour.

“If the government does not take decisive action, Germany is likely to remain at the bottom of the growth table in the euro area,” said Ralph Solveen, an economist at Commerzbank.

GDP growth in 2Q23
GDP growth in 2Q23


But at least some of Germany’s troubles can be traced back to tighter monetary policy.

The central bank has consciously dampened economic activity via higher rates in an attempt to bring inflation, which at one point last year was in double digits, to its 2% target.

Higher borrowing costs hurt manufacturers particularly hard because they depend on investment and no euro zone country has a larger industrial sector than Germany.

“To loosen monetary policy because Germany is in a difficult position would be unwise but to tighten it would add macro pressure to the micro-level pressures that beset the economy,” Portes added.

This puts the ECB in a situation where it must contemplate wrapping up its tightening cycle before witnessing the sustained drop in core inflation it said it wanted to see.

Making such an explicit link between underlying inflation and the need for continued rate hikes may prove awkward for the ECB, which is now trying to shift the emphasis from raising borrowing costs to simply keeping them high.

“They’ve made a mistake in accentuating underlying inflation too much,” said Carsten Brzeski, global head of macro for ING Research, said. “The risk is that they have already gone too far.”

For Ricardo Reis, a professor at the London School of Economics, the ECB needed to start looking at the expected path of inflation “12 or 18 months from now” — as it traditionally did — rather than current readings.

Germany's manufacturing PMI, rate on new loans to euro area corporations
Germany’s manufacturing PMI, rate on new loans to euro area corporations


The first sign of a change in the narrative started at the ECB’s last meeting two weeks ago and caught markets by surprise.

After declaring in June the ECB was “not even thinking about pausing” its rate hikes, Lagarde changed tack in her latest press conference, going as far as saying she didn’t think the central bank had more ground to cover “at this point in time”.

Days later — and after data showed inflation excluding energy, food, alcohol and tobacco was stuck at 5.5% — the ECB chose to emphasise that most other measures of underlying prices had shown signs of easing.

And ECB board member Fabio Panetta then made the case for “persistence” in keeping rates high rather than raising them further.

All this set the stage for a possible pause in rate hikes in September, likely coupled with an option to come back for more if needed and a pledge to keep borrowing costs elevated for a while.

But markets even doubt the high-for-longer scenario, with substantial rate cuts priced in for the second half of next year.

“We continue to expect the ECB to pivot significantly over the next few months, with no further hikes this year and March kicking off a series of rate cuts,” economists ABN-AMRO said in a note to clients.

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