Most people probably don’t care too much about the prices of Italian government bonds. They have other concerns such as high inflation. To combat rising prices, the European Central Bank started a new course last week. The key interest rate will increase, further bond purchases have ended. Finally, it has to be said, because the central bank hesitated too long to fulfill its primary task: to keep prices stable.
This long overdue change in interest rates has strengthened interest in speculating on the stock markets. The trend can be described by the following question: If interest rates rise, will Italy and other financially weak countries in the euro area still be able to pay off their debts at all? Probably not, many believed, so a few days after the historic ECB decision, there were attacks on Italian government bonds. As a result of the sale, interest on debt increased to over four percent, the highest since 2014.
Bad memories from 2011/2012 are coming. In those days, Mario Draghi’s promise of “whatever it takes” saved the monetary union from collapsing. But that promise has become fragile in the eyes of the financial markets. Therefore, a few hours after the ECB’s decision to change interest rates, investors again began to challenge the central bank: who is stronger?
Usually the answer is clear. No speculator can win against the central bank’s unlimited money reserves. But how far will the ECB go with its support purchases? Draghi’s existing rescue program known as OMT comes with some obligations. In order to benefit from central bank help, countries in need of aid must first implement economic policy reforms from the EU’s ESM bailout package. No euro area country wants to do this anymore, especially as EU rules on budgetary discipline are largely suspended anyway.
The countries of the euro area will continue to depend on cheap credit and hence low interest rates in the future. On the other hand, the central bank has to raise interest rates to control inflation. This conflict of goals is difficult to resolve – and the central bank has shown the world how much it is grappling with: Fighting inflation is already tough enough with the surprising calling of its extraordinary meeting on Wednesday. In addition, the ECB must now act as its guardian angel again. In this regard, central bankers promised after the meeting that they would buy Italian government bonds from existing reserves of 1.7 trillion euros in emergency to lower interest rates on loans.
The financial markets are ahead of the central bank
How exactly is this supposed to work? The ECB intervenes in the market if interest rates on loans of individual euro area countries are higher than would actually be justified on the basis of economic data. However, it is difficult to draw a clear line: when is the interest rate on loans “too high” because speculators are driving prices up? And when are high interest rates economically justified? Nobody can deny that the state of public finances in Italy is more uncertain than in Germany. As a result, Italy has to pay higher interest rates to compensate lenders for the higher risk of default. There will therefore be a lot of controversy about the difference between the Italian and German government bond yields at which the central bank should take action or leave the assessment of the price to the market.
Meanwhile, the financial markets are ahead of the central bank. They doubt that the existing trillion-dollar fund will be enough in an emergency – and sell Italian government bonds. Therefore, the ECB has now promised to develop a successor program for Draghi. It is likely that less stringent economic policy will be attached to this rescue package. The old question of whether a central bank is using this measure to engage in potentially illegal state funding is likely to experience a renaissance. The likely consequence would then be the resumed trials of the supreme courts.
The European Central Bank will have to live with this criticism. It makes sense not to give up her role as a lifeguard in times of need. There is no one in the EU to step in.