Global central bankers face the challenge of curbing high inflation without stifling growth. That’s hard enough. But European Central Bank President Christine Lagarde has an extra ball to juggle. She must also ensure the differences in bond yields between euro zone countries don’t widen to levels that undermine monetary policy, or even pose an existential threat to the single currency. Her various goals may become incompatible.
Euro zone bond yields leapt after Lagarde earlier this month opened the door to a rate rise this year. Particularly big swings in southern European debt mean the spread between German and Italian 10-year government bonds has widened nearly 40 basis points this year to around 170 basis points, the most since July 2020. That’s mainly because the ECB plans to stop buying bonds before it raises rates: the sooner it wants to hike, the sooner it must halt purchases.
Any new cunning schemes would, however, face a fundamental problem. High inflation requires the central bank to tighten monetary policy. Rate hikes, no matter how gradual, would be at odds with bond purchases, which are effectively a loosening of policy. That’s in contrast to the past decade, when inflation was too low and bond purchases could be justified as a way of nurturing price pressures as well as reining in yield spreads.
If such assumptions prove right and current price pressures ease, the ECB may yet avoid having to choose between curbing inflation and controlling yield spreads. If not, these two goals will become incompatible as never before.- The yield premium that 10-year Italian government bonds offer over their German counterparts rose on Feb. 14 to 170 basis points, the most since July 2020.
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