The author is professor emeritus at the Stern School of Business, NYU and chief economist at Atlas Capital Team
Faultlines in the eurozone are resurfacing. In response to a sharp widening of sovereign bond yield spreads in Italy and other states, the European Central Bank held an emergency meeting on Wednesday. Its governing council decided to work on designing a new facility to address “fragmentation risk”, or the idea that the effect of monetary policy on the 19 nations in the eurozone may vary widely, with potentially destabilizing consequences.
The dangers are real. Italian long-term yields have surged from below 1 per cent at the start of the year to above 4 per cent in recent days. But fragmentation risk is not the only serious problem for the ECB. In recent months, inflation in the eurozone has also surged above 8 per cent. This is at a similar level to the US, but, unlike the Federal Reserve, the ECB plans to wait until next month to start raising interest rates. This lag behind the Fed and other central banks is due to a variety of reasons. There is more slack in labor and goods markets in the eurozone than in the US as the area’s recovery from Covid-19 has been more sluggish.
Supply shocks, including soaring energy prices and those of other commodities following the Russian invasion of Ukraine, are a greater factor than excessive aggregate demand in driving eurozone inflation. Wage growth is more modest than in the US, and the rise in core inflation is smaller.
Supply shocks that reduce growth and push up inflation present all central banks with a dilemma. To prevent inflation expectations from getting out of control, they should normalize monetary policy sooner and faster. But that risks a hard landing of the economy, with recession and rising unemployment. If, on the other hand, the banks also care about economic growth and jobs – as even the ECB does, in spite of its single mandate of price stability – they may normalize more slowly and risk de-anchoring inflation from its expectations.
The US and the UK are currently at serious risk of a hard landing as the Fed and Bank of England aggressively tighten rates. But this risk is at least as large, and most likely greater, in the eurozone than in the US. The recovery from Covid has been more anaemic in the region. It is more exposed to energy shocks from a long war in Ukraine. And given its reliance on exports to China, it is also more vulnerable to a slowdown of Chinese growth stemming from Beijing’s zero-Covid policy.
Moreover, the weakening of the euro that arises from the difference in ECB and Fed monetary policies is inflationary. The increase in borrowing costs for the eurozone periphery is larger. Some forward-looking indicators, such as German manufacturing data, signal that the area may be heading for a recession even before the ECB starts raising rates. All of this is happening as ECB hawks, keen to raise rates sooner and faster, are gaining the upper hand in the governing council.
The eurozone suffers from weak potential growth and job creation. A hard landing would not only exacerbate these problems but intensify market concerns about debt sustainability, or fragmentation risk. The “doom loop” between indebted governments and banks holding that debt, a feature seared into the minds of many by the eurozone crisis a decade ago, would come back into focus.
Designing a new facility to deal with fragmentation risk is easier said than done. ECB doctrine argues that potentially unlimited purchases of some governments’ bonds are acceptable only if widening yield spreads are driven by unwarranted market dynamics. When poor policies rather than bad luck are the driver, ECB bond purchases need to come with conditions attached. This is how the Outright Monetary Transactions facility was designed in 2012 but no government requested it because none wanted to accept the politically fraught conditions. Still, in order to pass legal muster, any new facility will need to include something along these lines.
The recent widening in Italian and other spreads is not just driven by irrational investor panic. Italy has low potential growth, large fiscal deficits and a huge, possibly unsustainable public debt that has grown during the pandemic. Now a permanent rise in debt servicing costs looms as the ECB withdraws its ultra-accommodative policies. The risk of a “doom loop” is higher in Italy than in the rest of the eurozone.
Next year’s Italian elections may produce a rightwing coalition dominated by parties bristling with scepticism about the euro and the EU. In practice, any new ECB facility designed to rescue Italian bonds may come with unacceptable conditions to the country’s new leaders – and to any other eurozone states under pressure.
Before this week’s ECB meeting, executive board member Isabel Schnabel stated that the bank’s willingness to deal with fragmentation risk had “no limits”. This echoed former ECB president Mario Draghi’s game-changing “whatever it takes” statement of 2012. But Schnabel also hinted at the need for policy conditionality when it comes to offering support. Given the current volatility of financial markets, one can expect they will further test the ECB’s ability to protect the currency union by backstopping fragile eurozone states.