The European Central Bank said on Wednesday it will take new steps to guard against rising borrowing costs in some highly indebted European countries. The announcement came after an unexpected meeting of the bank’s Governing Council amid growing concerns about the bond market.
Borrowing costs for eurozone countries have diverged sharply in recent weeks on expectations that the bank will raise interest rates. This widening gap, known as fragmentation, could affect the bank’s ability to manage monetary policy in the 19 countries that use the euro. Christine Lagarde, president of the bank, said last week that politicians “would not tolerate it”.
On Tuesday, Isabel Schnabel, a member of the bank’s executive board, described the fragmentation as “a sudden break” in the relationship between government borrowing costs and economic fundamentals.
Last week, the bank said it may consider using the reinvestment of bond-maturity proceeds in its 1.85 trillion euro ($1.9 trillion) pandemic-era bond purchase program to avoid this fragmentation, by buying bonds that would help reduce government borrowing costs. .
On Wednesday, the The bank confirmed that it would make these bond purchases in a flexible manner as well as “accelerate” the design of a new tool to combat market fragmentation, without giving further details.
The divergent spreads emerged as the central bank changed its policy to tackle inflation, which at an annual rate of 8.1 percent is the highest level since the creation of the euro in 1999. In addition to ending credit purchase programs bonds that have collected large amounts of government debt, the bank has also said it will raise interest rates in July for the first time in more than a decade. The move will be followed by another, likely larger, rate hike in September.
As traders bet on how much the central bank will raise interest rates to control inflation, there has been growing concern about the impact of higher rates on countries that have a lot of debt. Italy, which has the second-highest public debt-to-GDP ratio in the eurozone, has seen its 10-year bond yield rise above 4 percent this week for the first time since 2014. The gap between its yield and Germany’s, considered the region’s benchmark, has grown the most since early 2020, when the pandemic rattled bond markets.
“The pandemic has left lasting vulnerabilities in the eurozone economy that are, in fact, contributing to the uneven transmission of our monetary policy normalization across jurisdictions,” the bank said in a statement on Wednesday.
The announcement pushed down bond yields across the eurozone. Italy’s 10-year bond yield fell to 3.71 percent from 4.17 percent the day before. Its gap, or differential, with Germany’s performance also narrowed.
The European Central Bank faces a particular challenge in determining monetary policy in a variety of economies. On the one hand, it is tightening monetary policy in the face of “undesirably” high inflation, but on the other hand, it is trying to ease the financing conditions of some countries through the purchase of bonds.
“It will take a few days to see how the markets digest this, let alone any more details from the ECB,” Claus Vistesen, an economist at Pantheon Macroeconomics, wrote in a note to clients. “The presence of an anti-fragmentation tool means the ECB has more room to hike rates without widening spreads excessively.”