ECB is caught between high interest rates and high inflation

By: Frank Knopers

Last week, the ECB decided to end its bond-buying programme from July onwards. end. The central bank also forecast a rate hike of 25 basis points for the next meeting. After that, it will continue to raise interest rates step by step, with the aim of getting inflation back under control. These measures were supposed to strengthen confidence in the euro, but the opposite happened. Yields on Italian 10-year government bonds skyrocketed and the ECB had to pay within a week Returning to action. What went wrong?

Due to high inflation, central banks had to take measures to maintain their credibility. Official inflation in the currency union had already risen to a multiple of the inflation target of 2% on average, mainly due to high energy prices. Moreover, market interest rates had already risen, so the ECB could not afford to wait any longer before adjusting monetary policy. The timing could hardly be worse, because after the decision to end the bond-buying program, interest rates shot up.

Italy wins again

The deteriorating economic outlook of high inflation and rising interest rates is particularly affecting the financially weaker countries in the eurozone. Countries with high debts will pay much more interest, while their budgets will be bogged down in expensive compensation measures for consumers and businesses. Due to tax cuts on energy and fuel, governments are again facing budget deficits this year. As a result, the ECB's decision to stop buying government bonds led to a sharp rise in Italian interest rates. This week, the interest rate on an Italian 10-year bond rose to 4.2%. That was the highest level since 2013. The interest rate differential with a German 10-year government bond rose to 240 basis points, the highest level since the start of the coronavirus pandemic in 2020.

Interest rate differential between Germany and Italy widens further (Source: YCharts)

The ECB scheduled an emergency meeting on Wednesday to regain control of the situation. The outcome of these consultations was a Short Statement, in which the central bank reiterated what it already announced last week during the interest rate decision. Namely, that the interest and repayments of previously purchased government bonds will be rolled over in a flexible manner. In practice, this means that the central bank can reinvest around €200 billion in interest and repayments from previously purchased government bonds in government bonds of 'weaker' euro countries for the rest of this year.

The central bank also announced a 'Anti-fragmentation mechanism' This should prevent the interest rates of southern countries from rising further. The details of this program are yet to be revealed, but with pale enough to calm the market. The ECB succumbed to pressure from the southern countries and interest rates fell again. The interest rate differential between Italian and German government bonds also narrowed.

Problem solved?

The bond market calmed down somewhat and the ECB may raise interest rates next month. But is it really that simple? This week's emergency meeting shows that the market is still very fragile. And that the central bank may not have the right tools to bring inflation under control. An interest rate hike may help curb demand for goods and services, but that is not yet the main cause of high inflation. This is due to high energy prices and stress on logistics chains, supply-related problems that will be little changed by an interest rate decision.

High energy prices are mainly the result of the war in Ukraine and the subsequent economic sanctions against Russia. These are political decisions that lie outside the realm of monetary policy. An interest rate hike or termination of the bond-buying program will not solve these problems. In fact, it actually brings more unrest to the market. And not only in the economic, but also in the political domain. The thrifty German is again disadvantaged and the Italian is helped. Bad fiscal policy is rewarded. Anything to prevent confidence in the currency union from evaporating. This flight forward will weaken confidence in the euro in the long run and move savers towards alternatives, such as precious metals.

This contribution comes from Geotrendlines

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