The European Central Bank (ECB) has done something the Fed hasn’t dared try yet: It raised interest rates to a level it has never reached before.

After nearly a decade of negative interest rates, the ECB’s 2022 hikes took many by surprise. In just over a year, the central bank jacked up its rates from a historic low of -0.5% to a record 4%.

(Yes, the ECB had negative interest rates. Instead of paying banks interest on their deposits, the ECB charged banks every time they deposited funds into their account at the central bank.)

The era of negative rates is over now that the ECB is fighting inflation. Euro area inflation peaked at 10.6% in October 2022 and remains stubbornly high due to elevated energy prices and supply bottlenecks.

Meanwhile, in the U.S., the Fed is fighting a similar battle, but in September it decided to keep interest rates on hold for the time being.

The interest rate gap between the Fed and ECB—considered an important driver of foreign exchange rates—has narrowed this year. Some analysts believe this is a precursor to a stronger euro.

Beyond the euro, experts believe the ECB is walking a tightrope with interest rates. Losing its balance could send its economy tumbling, and the markets along for the ride.

All eyes on the ECB

In Europe, the ECB plays a vital role not just in shaping policy, but in influencing investors’ expectations about inflation, liquidity, and interest rates.

Today, the ECB’s credibility is intertwined with its ability to tame inflation. This fact was recognized over a year ago by MSCI, a global provider of stock and bond indexes, before the ECB raised interest rates.

“The outlook for markets depends crucially on the severity of the supply-driven economic shock, how decisively the European Central Bank responds and whether it maintains credibility in managing inflation,” MSCI wrote in June 2022.

Since that post was published, the ECB has raised interest rates 10 consecutive times. Yet headline inflation and core inflation both came in at 5.3% in August. Core inflation is usually lower because it excludes “volatile” goods such as food and energy. But not in the eurozone.

All the while, eurozone economic growth continues to stagnate. The region’s GDP grew just 0.3% in the second quarter of 2023 and is on track to expand a paltry 0.9% this year, according to the IMF.

If the ECB fails to get a grip on inflation while rates remain elevated, it could be a fatal combination for the eurozone and investors exposed to European markets.

Threat of “stagflation” grows

In its analysis, MSCI warned that the ECB’s inability to control inflation could lead to “stagflation”—a scenario characterized by weak economic growth, rising unemployment, and high inflation.

If this scenario plays out, it would cripple the eurozone economy and one of America’s largest trading partners.

Two-way trade between the U.S. and the EU (which includes 20 eurozone member states) was more than $900 billion in 2022, according to the Census Bureau.

According to MSCI, a portfolio of European stocks, bonds, and real estate could lose around 10% if this worst-case scenario plays out.

It takes a lot less to influence markets negatively. If investors think the ECB (or any central bank) isn’t doing its job, they typically de-risk and reallocate. This usually means capital flowing out of stocks and into bonds with the lowest risk profile.

According to the Wall Street Journal, this trend began earlier this year when investors reevaluated central banks’ plans for interest rates.

"There’s clearly a flight to safety in European bond markets,” said Shaniel Ramjee, a fund manager at Texas-based Pictet Asset Management.isn't just a concern of those directly invested in European markets.

Europeans' woes aren't just a concern for those directly invested in the old continent.

The ECB is one of the most influential central banks in the world, and it can impact markets the same way the Fed can. This means spillover effects from its policy decisions could impact Wall Street and the average investor regardless of their exposure to European stocks.