Unlike other monetary policy makers, the officials of the European Central Bank have the added challenge of setting one policy for many different countries, each with its own fiscal policy, economic outlook and level of debt.
As the bank tightens its easy money policy by raising interest rates and ending its multi-billion euro bond purchase programs, it is also trying to prevent government borrowing costs from spreading sharply across the eurozone and hampering the effectiveness of monetary policy.
On Thursday, the bank is expected to announce more details about a new political tool it is designing to stop borrowing costs that are not synchronized with a country’s economic fundamentals.
These differences between countries are most clearly reflected in government bond yields, a measure of government borrowing costs. Investors will demand higher returns from countries they believe are more risky to lend to, perhaps due to a history of debt default or political instability or slow economic growth.
Borrowing costs for Italy, which has one of the highest debt burdens in the eurozone have risen sharply since the European Central Bank confirmed its plans to raise interest rates. This week, they increased again when the country’s government fell apart, with Prime Minister Mario Draghi resigning on Thursday after key parts of the coalition government left him. The difference, or spread, between 10-year government bond yields in Italy and Germany is now about double what it was at this time last year.
The European Central Bank considers a sudden break in the relationship between government borrowing costs and basic economic conditions as so-called market fragmentation. It has said that it will not tolerate this, as it will reduce the effectiveness of the other monetary policy tools to bring down inflation.
It is “critical that funding conditions move largely synchronized across the euro area as we change our stance,” Luis de Guindos, the bank’s vice president, said earlier this month. “For two equally solid firms in the euro area, a change in monetary policy should lead to a similar reaction in their financing terms, regardless of which country they are domiciled in.”
At the end of June, the bank announced that from the beginning of July it would implement its first line of defense against fragmentation by managing the reinvestment of maturing bond income in its 1.85 trillion euro ($ 1.88 trillion) bond purchase program from the pandemic. to bonds from countries that will best support its monetary policy objective of consistency. For example, it can use the proceeds of maturing German bonds to buy Italian debt.
At the same time, the bank said it was working on a new tool to stop widely divergent borrowing costs for some countries. Internal disagreements had to be overcome over the design of this tool to ensure that it did not encourage governments to be fiscally irresponsible in the belief that the central bank would come to the rescue.
The central bank has been through this battle before. At the height of the eurozone’s sovereign debt crisis a decade ago, the central bank sought to devise a political tool that would be in line with the commitment of Draghi, then president of the European Central Bank, to do “anything” to save the euro. It faced many political and legal challenges.
Finally, the tool, which would allow the bank to make unlimited purchases of a country’s debt if the country was part of a formal rescue and reform program, was never used.
The new tool is expected to provide fewer conditions for a country to benefit from it.