Why is the ECB so dovish on interest rates? Investment Monitor

Against a backdrop of rising inflation, the European Central Bank (ECB) decided to raise interest rates for the first time in more than a decade. The 0.5 percentage point rise was twice as large as the rise hinted at by ECB officials a few weeks earlier, a sign of the tightening of monetary policy in the euro zone.

Bank officials Explain the rapid rise in rates due to their inability to raise rates in June, due to earlier promises that rates would not rise again until July.

Compared to the US Federal Reserve and the Bank of England, which have raised their policy rates by 1.5 and 1.25 percentage points respectively since the start of 2022, the ECB’s approach remains relatively accommodative.

One of the probable reasons is that the current rise in inflation in Europe is much more due to external factors. In the United States and the United Kingdom, food and energy prices are responsible for just under half of inflation until June 2022, but in Germany, Greece, Spain and Italy, this figure is more than two-thirds. Excluding food and energy, none of these countries experienced inflation significantly above target.

Inflation in the food and energy sectors is largely not due to excessive demand but to tight supply, a direct consequence of the Russian war in Ukraine. Easing these pressures will not depend on monetary policy but on diplomacy and the progress of the war.

Difficulties in finding a common EU solution

Another reason for the ECB’s more cautious approach is the structure of the Eurozone. As a union of states sharing a common currency but issuing their own sovereign debt, the Eurozone faces the perennial problem of spreads.

Italian bonds, for example, generally generate higher yields than German bonds, due to differences in risk perception. When this gap widens, the implementation of a pan-euro area monetary policy becomes much more difficult. Germany may want the ECB to raise interest rates to fight inflation, but an Italian government that is already handing out generous returns to investors could be pushed into default.

The spread on ten-year Italian bonds has doubled since October 2021, including a particularly sharp increase in recent weeks as the resignation of Prime Minister Mario Draghi led to a dramatic sell-off in Italian debt.

But above all, the announced rise in interest rates was accompanied by a new tool for the European Central Bank, the transmission protection instrument (TPI). The TPI will allow the ECB to buy bonds in bulk from governments struggling with rising yields, a move long resisted by the bloc’s currency hawks.

The TPI should give the ECB more leeway to cut spreads without forcing southern European governments into deeply damaging austerity programs. The aid will, however, be conditional on countries like Italy adhering to EU fiscal rules and meeting the conditions of the bloc’s recovery fund.

That the TPI was announced at the same time as an unexpectedly large increase in interest rates did not go unnoticed, with speculation that the measures were two sides of a unique deal between the bloc’s monetary hawks and doves. If this political agreement will hold over the next few months and if the TPI will survive anticipated legal challenges, remains to be seen.

Edward N. Arrington