Can the Fed and the ECB Steer between Inflation and Recession?

H ealthy banking systems are vital to economies. Right now, Europe appears to be in recession as its banking system contracts because of the European Central Bank’s failure to coordinate its interest-rate and balance-sheet policies. The Federal Reserve faces similar issues.

For both the euro zone and the U.S., declines in banking assets, adjusted for inflation, are associated with recessions, as illustrated in the following charts:

In the euro zone, declines in real bank assets (net deposits at central banks) are most closely linked to the 2008–09 Great Financial Crisis (GFC) and subsequent euro crisis. Bank assets also declined during the low-growth period of 2001–02. The current asset downturn is twice as severe as any of these previous episodes.

For the U.S., the graph below tells a similar story:

Downturns in real bank assets invariably are associated with U.S. recessions. Only during the brutal Arab oil embargo and GFC recessions did we see greater bank-asset downturns than we see at present.

Looking across the Atlantic, the economic recession that accompanied the euro-zone crisis in the financial markets was in no small part the result of strains in euro-zone banks that were made worse by reductions in LTRO. This history is repeating itself. Growing difficulties in the euro-zone economy are the direct result of the ECB’s contraction of its loans to banks. European businesses rely much more heavily on bank financing than do their U.S. counterparts, so, to provide monetary stimulus to these borrowers, the ECB created a facility called the Long-Term Refinancing Operation to lend on easy terms to banks that can then relend to their customers.

This facility has been a major component of the ECB’s stimulus program following financial crises. After the GFC, the ECB made a radical 60 percent contraction to LTRO that resulted in an 8 percent decline in euro-zone bank assets immediately preceding the 2011–13 recession during the euro crisis. Today’s comparable 78 percent LTRO contraction is making a similar contribution to Europe’s looming recession. The following chart displays each LTRO drawdown as a percentage decline in the LTRO level from its previous peak:

Large percentage declines in LTRO in the early 2000s can be ignored because the facility was very small at the time.

In response to the GFC, it was ramped up to €858 billion along with other loans to banks, but then, in a premature attempt to return to traditional central-bank policies, this support was sharply reduced in 2010, immediately before the recession began. This contraction of lending to banks dried up liquidity needed to finance government borrowing on the euro zone’s periphery. After acute strains in the money markets during the euro crisis, LTRO was boosted back up to over €1.1 trillion by 2012. Stepped-up bond-buying, and then–ECB president Mario Draghi’s famous “whatever it takes” policy, provided cover to draw down LTRO without ill effects following the euro crisis, but the pandemic led to another huge expansion of LTRO — to €2.2 trillion by mid 2021 — before, once again, a precipitous reduction of nearly 80 percent. Consequently, bank assets fell more than 20 percent, bringing the euro zone to recession’s threshold.

Euro-zone inflation has peaked as LTRO was reduced, but the U.S. experience demonstrates that disinflation is attainable without recession, and the ECB’s hasty LTRO drop contracted bank lending and likely the economy.

In the U.S., the Fed relies on open-market securities purchases for monetary stimulus, which can affect asset prices. The figure below shows cumulative securities purchases and bank-asset growth since the beginning of 2020:

The Fed responded to the pandemic crisis initially with $3 trillion in securities purchases, among other measures, with an additional $2 trillion of quantitative easing (money-supply growth) into 2022. Bank assets first jumped by $1 trillion and rose an additional $3 trillion through 2022. Since then, bank assets have plateaued as the Fed’s securities portfolio was trimmed by 20 percent. During this time, contraction in the Fed’s reverse-repo deposit facility for nonbank financial institutions has produced a flow of funds out of the Fed and back into the financial markets, which has offset the Fed’s quantitative tightening that removes liquidity from the markets to the Fed. At its current shrinkage rate, reverse repos will disappear around April 2024, which should increase the contractionary pressure of quantitative tightening on the financial markets and the economy.

For all the balance-sheet gyrations, as well as the more widely followed interest-rate hikes, both Europe and the U.S. are experiencing hoped-for disinflation. But the causality is questionable. In both the euro zone and the U.S., fiscal deficits closely track the ebb and flow of inflation over the past few years. The following graph depicts the correspondence for the euro zone:

Euro-zone inflation closely follows lagged fiscal deficits. In the U.S., too, there is a strong relationship between the government’s borrowing and subsequent inflation, shown below:

The U.S. saw its pandemic-era deficit skyrocket in 2020 and continue to grow through 2021, while euro-zone government deficits built more slowly to a 2021 peak. Each economy saw inflation peaking and then falling, following deficits down with a 14- to 18-month lag. In looking at the possible inflation effect of current deficits after this lag, U.S. fiscal incontinence suggests the possibility of inflation rising again from its current low, while the euro zone’s superior fiscal discipline should keep its inflation quiescent.

It appears the central banks have been skillful at bringing inflation down, but, if deficits are the root of pandemic-related inflation, the likelihood is that central banks will prove no more able to influence deficit-fueled inflation than they were able to boost pre-pandemic inflation to their targets. Fortunately, deficit-fueled inflation appears transitory, lasting little more than a year, but if deficits themselves are persistent, such transience may not matter for inflation control. The Fed and the ECB must navigate between the Scylla of bank contraction and recession and the Charybdis of fiscal inflation. The ECB is scraping along recession. The Fed now seems to be in the clear, but it may be on a path to hit both.