ECB faces challenge to avoid sovereign debt crisis

Faced with record high inflation, the European Central Bank (ECB) has continued its tightening of monetary policy by announcing the termination of its asset purchase programme (APP) at the end of this month.

The APP, which includes purchases of asset backed securities, covered bonds, corporate bonds and government bonds, reached just under €3.25 trillion last month. This is the larger and first quantitative easing (QE) programme, originally introduced to fight deflationary pressures.

The second programme which was introduced to aid with the pandemic (pandemic emergency purchase programme, or PEPP) had ended back in March, holding a further €1.7 trillion of government bonds.

With QE coming to an end, the ECB can now start to raise interest rates, in an effort to reduce staggeringly high inflation pressures. ECB president Christine Lagarde today said that the bank will raise its main policy interest rates by 0.25% at the next meeting in July, with further hikes to follow.

Lagarde said that unless there is an improvement in the medium term inflationary outlook, interest rates may need to raise by more than 25 basis points in September. While this is three months away, we are unlikely to see a material improvement in the outlook for inflation, and so investors should expect the deposit rate to turn positive in September (0.25%), and the main refinancing rate to reach 0.75%.

We forecast another 0.25% rise in October, before the ECB pauses its increases.

It is a major challenge for the ECB to tighten policy without triggering a debt crisis in peripheral Europe, especially Italy. The bank announced that its holdings of government bonds under the PEPP could be redeployed to stop any significant rise in the cost of borrowing for peripheral governments compared to the core.

As the announcements were being made, there were some notable market moves. First, government bond yields rose, suggesting that today’s announcement was more hawkish that expected.

Second, the spread, or additional cost of borrowing for Italy compared to Germany increased further. This suggests that investors were left more worried after the ECB’s commitment to stop such increases.

Finally, having initially risen against the US dollar, the euro has since fallen back on the day. Despite the more hawkish comments and higher yields, it seems international investors are becoming increasingly concerned about the risk of another debt crisis in peripheral Europe.

It is early days, but with crucial elections in Italy, Spain and Greece next year, political risk may once again return to interfere with how the ECB should and can set monetary policy.