The ECB has the toughest central bank juggling act

ECB President Christine Lagarde attends a news conference in Frankfurt, Germany October 28, 2021. REUTERS/Kai Pfaffenbach

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LONDON, Feb 15 (Reuters Breakingviews) – Global central bankers face the challenge of reining in high inflation without stifling growth. It’s quite hard. But European Central Bank President Christine Lagarde has an extra ball to juggle. It must also ensure that bond yield spreads between eurozone countries do not widen to levels that undermine monetary policy or even pose an existential threat to the single currency. Its different objectives can become incompatible.

Eurozone bond yields jumped after Lagarde earlier this month opened the door to a rate hike this year. Particularly large swings in southern European debt mean the spread between German and Italian 10-year government bonds has widened by almost 40 basis points this year to around 170 basis points , the most since July 2020. This is mainly because the ECB plans to stop buying bonds before it raises rates: the sooner it wants to go up, the sooner it has to stop buying.

If yield spreads were to continue to rise, weaker economies like Italy or Spain would suffer and investors might even begin to doubt some governments’ ability to repay their debt. Still, Pictet’s Frederik Ducrozet estimates that the spread between Italian and German bonds should reach around 250 basis points before the ECB starts to worry. Lagarde herself said she had the tools to respond if needed.

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The French has options. Even after a pandemic-era bond-buying program ends, proceeds from maturing bonds will be reinvested. Citi analysts estimate that around 20 billion euros per month could therefore be deployed to cap southern European bond yields. But that may be too little to combat a blowout like the one in 2020 or the eurozone sovereign debt crisis in 2012. If so, Lagarde could dust off a purchase plan, called Outright Monetary Transactions, mentioned by his predecessor Mario Draghi. Yet the strings of reform attached to this agenda can prove unpleasant for governments. ECB chief economist Philip Lane may therefore have to come up with an alternative program that both helps weaker sovereigns and does not breach ECB rules against government funding.

Any clever new scheme would run into a fundamental problem, however. High inflation forces the central bank to tighten monetary policy. Rate hikes, no matter how gradual, would contradict bond purchases, which are in effect an easing of policy. This contrasts with the past decade, when inflation was too low and bond purchases could be justified as a means of maintaining price pressures as well as limiting yield spreads.

Admittedly, a sharp widening of bond yield spreads could harm growth in the southern euro-zone countries and automatically depress inflation. But that assumes that the global forces that have contributed to higher consumer prices, such as supply chain distortions and high energy costs, disappear. It also assumes that wages will not rise faster to catch up with inflation, especially in stronger economies like Germany.

If these assumptions turn out to be correct and current price pressures ease, the ECB could still avoid having to choose between controlling inflation and controlling yield spreads. Otherwise, these two goals will become incompatible like never before.

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– The yield premium offered by Italian 10-year government bonds over their German counterparts increased on February 14 to 170 basis points, the highest since July 2020.

– European Central Bank President Christine Lagarde said on Feb. 3 that the ECB has the tools to respond to widening spreads if needed.

– “We are not seeing such a development and although yields have increased, spreads have not widened significantly,” she told a news conference. “We are looking at these issues very carefully. We have no reason to believe it will be any different. If this were the case, we will obviously react, and we have all the tools, all the instruments and the appropriate flexibility if this is justified.

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Editing by Neil Unmack and Oliver Taslic

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