The writer is chief economist at German bank LBBW
As inflation rises in the eurozone, the pressure is inevitably building for the European Central Bank to step up planned monetary policy action.
In March, European Central Bank president Christine Lagarde explained how the overdue normalisation of monetary policy was envisaged in Frankfurt: in the third quarter, bond purchases could be reduced to net zero with only maturing securities to be replaced. Only then would interest rates be raised “gradually”.
The ECB is likely to be concerned that a more rapid normalisation of monetary policy, comparable with moves by the US Federal Reserve or the Bank of England, could entail risks to financial market stability. For this reason, it may prefer to move only cautiously, almost as if on eggshells.
What seems to be the problem? A key concern appears to be Italy. Will the country be at risk of descending into a debt abyss if super-loose interest rates rise?
The ECB may feel it has been wrongfooted once. Back in March 2020, Lagarde stated in one of her first press conferences that the ECB was not there to close government bond spreads. That is not wrong, of course. But her words had not yet faded away when a formidable sell-off of Italian government bonds began, worse than on any single day of the euro crisis. Lagarde had to row it all back immediately.
But the ECB needs to leave the difficulties of that day behind. It should not stand in the way of tightening monetary conditions more courageously than it has hitherto communicated. The fear that Italy’s high debt load could pose a challenge to monetary normalisation cannot be dismissed out of hand. But Italy’s resilience has become much more solid than many doomsayers give it credit for.
Last month’s announcement from Lagarde that the ECB would end its colossal bond purchases sooner than generally expected provoked a comparatively restrained reaction in Italian government bonds.
For sure, it will not be without consequences if the ECB stops buying the equivalent of all new issues of euro government bonds, as has been the case for the past two years. Interest rates have already risen. Spreads are likely to widen further. But that is a healthy market response and should not be feared.
Italy is in a better position than many observers believe: high inflation is reducing government debt. With inflation-driven nominal growth of 10 per cent, Italy’s debt ratio falls by 15 per cent of GDP in 2022, other things being equal. That helps.
It helps even more that effective interest rates are very low. Italy pays an average interest rate on its outstanding debt that has declined to only 2 per cent, right at the ECB’s inflation target and well below inflation. Higher-yielding bonds issued a decade ago are still maturing and can be refinanced more cheaply today. The effective interest burden will therefore remain low or even fall for a few more years.
Something else is both unusual and favourable. Italy currently has a stable and competent government that enjoys broad parliamentary support. This is by no means a matter of course in a country where the last “elected” prime minister, meaning the candidate heading the victorious party list, was one Silvio Berlusconi, almost fifteen years ago.
Finally, Italy will have to issue less debt than many realise. The average life of Italy’s public debt is seven years, even if the Treasury has not taken advantage of the super low rates to extend its maturity profile. Only a small portion needs refinancing every year. And Rome busily pre-funded in the first quarter while the ECB’s €1.85tn “pandemic emergency purchase programme” of asset buying was still up and running.
Rome’s borrowing needs will be further reduced through substantial budgetary relief from the Next Generation EU reconstruction fund. Between 2023 and 2025, Italy can expect annual grants of more than 1 per cent of its gross domestic product and a little more than that again through cheap EU loans.
This makes it much more likely that prime minister Mario Draghi will be able to push through structural reforms to address Italy’s growth weakness than any of his predecessors, including Mario Monti, who had to run austere public finances.
The risk of inflation getting out of control is rapidly rising. The ECB must shift up a gear. The worry that Italy cannot cope financially is unfounded. It can and it will. All the stars are aligned, and it won’t get any better than this. The longer Lagarde hesitates, the more likely it becomes that an Italian government crisis will get in the way. Then it would get truly tricky to increase rates. Don’t wait!