To Please Monetary Hawks, the ECB Must First Betray Them


The European Central Bank’s responsibilities have sometimes seemed to boil down to one thing in recent years: easy money. Ironically, it is the tight-money lobby that must now embrace liquidity.

A week of turmoil in bond markets has highlighted the challenge of raising interest rates without causing a debt selloff among the weakest eurozone nations. Last week, the ECB emphasized it would address this by flexibly reinvesting its maturing bond portfolio, but this isn’t nearly enough firepower. Officials were forced to call an emergency meeting Wednesday.

The ECB will “accelerate the completion of the design of a new anti-fragmentation instrument for consideration,” the central bank said after the meeting. It is a step, but not exactly a thrilling call to action.

Indeed, investors still seem to believe the risk of the eurozone fragmenting will impact the central bank’s tightening plans. The euro, which had initially jumped, gave back its gains after Wednesday’s statement. Italy’s 10-year paper is trading at 2.2 percentage points above Germany’s, which is the widest since the onset of the Covid-19 crisis in 2020. The country would pay a 4% yield on new debt, for the first time since 2014.

Things aren’t as dire as during the euro crisis, when investors bet on the currency zone’s disintegration. Right now, it is expectations of higher rates that are leading all government bonds to sell off. It is natural that Southern European debt—which is more volatile and less liquid—is disproportionately affected. Two-year spreads, which are a bellwether of immediate panic, are more contained.

Still, Italy remains an existential threat for the euro in an environment of rising borrowing costs. If yields stay at today’s levels, the country’s interest payments would cumulatively after three years increase by roughly 1.5% of gross domestic product, or between 25 billion euros—equivalent to $26 billion—and €30 billion, Scope Ratings analyst Alvise Lennkh-Yunus estimates. It would bring total debt servicing costs up to around where they were during the euro crisis.

This needn’t happen, though. Any debt crisis in the eurozone is of the ECB’s own making.

On Tuesday, board member Isabel Schnabel said the ECB’s commitment to fight fragmentation in bond markets had “no limits,” but reiterated that spreads on Italy’s and Spain’s bonds should be wide enough to reflect these countries’ fundamental probability of default. This is a fiction: The Federal Reserve ensures that no default risk is priced into the Treasury market at whichever level of interest rates, and so does the ECB. If Italy is always granted liquidity to refinance its debt, does paying higher interest costs bring it closer to default? No. Conversely, an Italian default could end the ECB’s very existence.

Eurozone hawks correctly see the fight against fragmentation as the stealth mutualization of different nations’ debts. But the point is moot: Rightly or wrongly, these countries have joined in a single currency. This means that monetary policy can only be effectively deployed if the target for spreads is zero—or at least a small number. This commitment can be fudged when the ECB is loosening policy on all fronts, but will need to be made much more explicit when rates start rising in July.

If tighter money is to last in the eurozone, debt-mutualization policies will need to be looser than ever.

Write to Jon Sindreu at [email protected]

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