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To please the monetary hawks, the ECB must first betray them

The responsibilities of the European Central Bank 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 triggering a debt sell-off among weaker eurozone countries. Last week, the ECB stressed that it would solve this problem by flexibly reinvesting its portfolio of maturing bonds, but this is not enough firepower. Officials were forced to call an emergency meeting on 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’s a milestone, but not exactly an exciting call to action.

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

Things are not as dire as during the euro crisis, when investors were betting on the disintegration of the currency area. Right now, expectations of higher rates are driving all government bonds to sell. It is natural that the debt of southern Europe, more volatile and less liquid, is affected disproportionately. Two-year spreads, harbingers of an immediate panic, are more contained.

Still, Italy remains an existential threat to the euro in an environment of rising borrowing costs. If yields remain at current levels, the country’s interest payments would cumulatively increase after three years by about 1.5% of gross domestic product, or between €25 billion, or $26 billion, and $30 billion. euros, said Alvise Lennkh-Yunus, analyst at Scope Ratings. . This would bring the total cost of debt servicing roughly to where it was during the euro crisis.

That doesn’t have to happen, though. Any debt crisis in the Eurozone is the work of the ECB.

On Tuesday, board member Isabel Schnabel said the ECB’s commitment to tackling bond market fragmentation had “no limits”, but reiterated that spreads on Italian and Spanish bonds should be large enough to reflect the fundamental probability of default of these countries. It’s a fiction: the Federal Reserve ensures that no default risk is priced into the Treasury market regardless of the level of interest rates, just like the ECB. If Italy is still being granted cash to refinance its debt, does paying higher interest charges bring it closer to default? No. Conversely, an Italian default could end the very existence of the ECB.

Eurozone hawks rightly see the fight against fragmentation as the stealthy mutualisation of the debts of different nations. But the point is debatable: rightly or wrongly, these countries have joined a single currency. This means that monetary policy can only be deployed effectively if the deviation target is zero, or at least a small number. This commitment may be faked when the ECB eases policy on all fronts, but will need to be made much more explicit when rates start to rise in July.

If monetary tightening is to last in the euro zone, debt mutualisation policies will have to be more flexible than ever.

Write to Jon Sindreu at jon.sindreu@wsj.com

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Post expires at 6:09pm on Sunday June 26th, 2022