It’s not what you hope will happen when you take a major interest rate decision as a central bank: turmoil in the financial markets – and then have to hold an emergency meeting, in which you are forced to soften your earlier decision. This unfortunate scenario has now become a reality for the European Central Bank.
Wednesday morning it was announced that the ECB board would hold an “ad hoc” meeting to discuss “market conditions”. That was code for: the rapidly rising interest rates on government bonds in Italy and, to a lesser extent, in other southern European countries such as Spain and Greece.
Those rising interest rates in Southern Europe were an unintended major effect of the decisions taken during the regular ECB meeting last Thursday in Amsterdam. The ECB then announced that it wanted to raise interest rates across a broad front in order to tackle rising inflation. The ECB will stop, among other things, from buying up extra government bonds, with which it has depressed interest rates on the capital markets in recent years.
Wednesday the ECB said it was willing to continue to buy Southern European debt specifically, to continue to push interest rates there. This is how it works: bought up loans from euro countries that are expiring are now more often replaced by southern European ones. As a result, the total balance sheet of the ECB is not growing (for the time being).
That government bond yields would rise after Thursday’s decision was logical and also the intention: higher interest rates tame inflation. Only, according to the central bank, there is now “fragmentation” in the eurozone. The interest rates of vulnerable, debt-laden countries, such as Italy, are rising faster than those of, for example, Germany and the Netherlands. The interest rate differential between Germany and Italy, the so-called spread, was below 2 percentage points before Thursday’s regular meeting, and then rose to 2.5 percentage points on Tuesday afternoon. On Wednesday morning, when it was announced that the ECB would hold emergency talks, the interest rate spread fell again to 2.2 percentage points. The ECB did not completely tame the spread: it stood at around 2.25 percentage points at the end of the afternoon.
These are very strong market movements in the bond markets, which indicate stress. Widening spreads were an important stress indicator during the euro crisis whatever it takes
Now, in a sense, it still does. Not only are government bonds of euro countries, which the ECB bought during the corona pandemic, being replaced by Italian or other southern European loans. Preparations are also being made for a new buying program, purely aimed at countries whose spreads are widening too much. The ECB speaks of a ‘new anti-fragmentation tool’.
Although a euro crisis is not imminent this time, the ECB is still concerned: if the differences in market interest rates are too great, it will be increasingly difficult to conduct a single monetary policy effectively across the eurozone.
This puts the central bank in a dilemma. On the one hand, interest rates have to go up to tame inflation. On the other hand, the interest rates on southern European government debts must be kept within limits. The general monetary policy works against the specific policy for weak countries.
Once again, the ECB must intervene to keep the eurozone stable, a role that many (including within the ECB) believe belongs to politics. In March 2020, when the corona crisis reached Europe, ECB President Christine Lagarde had said: “We are not here to squeeze spreads”. However, it is inevitable that the ECB will keep countries like Italy going. Italy’s public debt, which has been underperforming economically for years, rose from 134 to more than 150 percent of GDP during the pandemic.
Also read: The ECB spins in the whirlwind of inflation
It makes it even more difficult for the ECB than for other major central banks (which do not have a fragmentation problem) to fulfill its main mission: to achieve price stability, or inflation of around 2 percent. In May inflation in the eurozone was 8.1 percent. In the United States, where inflation has been going on for some time, 8.6 percent.
There, in the US, expectations about the outcome of the meeting of the central bank, the Federal Reserve, rose rapidly. The Fed met Tuesday and Wednesday this week. On Friday, the consensus in the financial markets was that an interest rate hike of half a percentage point would be imminent. But when inflation turned out to be much higher than the slight decline hoped for in May, expectations skyrocketed. On Monday morning, analysts concluded from movements in the US money market that the chance of a 0.75 percentage point interest rate hike was already significant. By the end of that day, that was almost the consensus. And on Tuesday, an interest rate step of a full percentage point was even taken into account.
Investors assumed on Wednesday that the Fed will not be going against market expectations anytime soon and that a 0.75 percentage point increase in the Federal Fund Rate, the main interest rate, is almost certain. On the other hand, Fed President Jerome Powell talked about 0.5 percentage points after the last meeting. He should now break with that.
A move of 0.75 percentage point would bring the main interest rate to between 1.50 percent and 1.75 percent. The fact that there is a lower and an upper limit here has to do with an important difference between the eurozone and the US. The European Central Bank dictates its interest rates to the market. By manipulating the amount of money in the money market, the Fed is trying to indirectly bring about the desired rate. That is why there is a bandwidth, in this case between 1.50 and 1.75 percent. The main ECB interest rates are still at minus 0.5 percent (for banks that deposit money with the ECB) and 0 percent (for banks that borrow from the ECB). These interest rates are expected to be half a percentage point higher after the summer, but a larger increase is also conceivable.
Wednesday evening at the Fed will quickly turn the discussion on possible further rate hikes. In the financial markets, futures trading points to a further 0.75 percentage point increase in July and September, followed by a 0.5 percent step in September and 0.25 percentage point in December. By then, at the end of this year, the interest rate will be between 3.5% and 3.75 percent – a stark contrast to the European Central Bank.