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© Reuters.

Mike Dolan

PARIS (Reuters), – PARIS, France (Reuters) – The European Central Bank is losing its ‘whatever’ commitment to binding the euro area. It is trying to normalise monetary policy while giving inflation hawks more control over how it does it.

On Thursday, the ECB declared that inflation has reached an unacceptable level and warned it would not fall below the 2% target in the three-year forecast horizon. The announcement came after new purchases of bonds from the ECB’s long-running bond buying programme ended July 1.

Christine Lagarde of the ECB stated that although she believed it was ‘committed’ to avoiding the so-called fragmentation’ between borrowing costs within euro area members, bond buying ended. Financial markets however were not as certain.

Investors are skeptical that Lagarde’s new approach to ECB policymaking – which seems to give more voice to national central bank and country with a more hawkish monetary stance than those at the center – will permit the same open-ended commitment by the periphery to reduce debt costs as Mario Draghi.

The end of the two-year-old euro debt crisis was ended by Draghi’s 2012 London speech that included his seminal “whatever is necessary” comment. He may now be worried that those words might not resonate with the markets 10 years after they were first spoken as Italy’s Prime Minister.

Italy’s sovereign bonds were the second largest euro debt market and an indicator of sentiment towards high-debt euro sovereigns. They plunged following Thursday’s announcements. Both nominal yields in Italy and relative yields to German benchmarks ballooned.

Futures markets valued 1.2 percent more ECB increases between July’s announcement and year end. Italy’s 10-year yield rose 20 basis points to reach 3.715%, its highest point since 2018. It is just a fraction of eight-year-peak levels.

Worryingly, the Italian 10-year bond risk premium over Germany has increased to 225 basis points. This was its highest point since the outbreak of the Pandemic of 1918. The pandemic forced several fiscal rescues. Italy’s debt soared to record 160% of GDP.

Frightening Fragmentation

Olivier Blanchard, an ex-chief economist of the International Monetary Fund said that he was concerned the ECB didn’t have enough tools to convince investors fragmentation can be managed.

Blanchard believed that the ECB’s monetary tightening was not sufficient to manage inflation. This was because the US labour market was much more tight than in America, so ECB tightening should not be a problem in terms of debt sustainability.

He said that bond investors needed to believe this because an excessive rise in long-term borrowing cost could change these sustainability metrics, creating a problem that the ECB will eventually have to solve.

Blanchard is a Peterson Institute for International Economics senior fellow. Blanchard said, “My biggest worry about the ECB”

Blanchard explained that even if investors think you’ll put in a lot, but not enough they will still want a higher spread. Blanchard said, “I am concerned at this stage that ECB does not have a mechanism with which it can intervene sufficient to resolve this. I believe this will be an issue over the next year.”

Lagarde argued that the central bank was able to handle any subsequent fragmentation even though the ECB had announced the termination of the Asset Purchase Programme. It was established in 2014 by the ECB to prevent potential deflation.

Lagarde said that she would deploy existing instruments adjusted or any new instruments if it was necessary. But we remain committed, committed to the correct transmission of our monetary policy.

However, “proper” can be a fuzzy concept when tightening the underlying monetary policies – not unlike 2012-14 when it was easier to align the policy with the deflation picture. In the same way, many people are still unclear about the objection to the ECB’s statement regarding “unwarranted fragmentation”.

What’s more, ECB sources told Reuters after the meeting that there was a large majority of policymakers against announcing a new fragmentation-fighting tool this week.

It seems unlikely that any coupon proceeds or mature bonds purchased through the Pandemic Emergency Purchase Programme, PEPP (a separate program), could be used in case of unforeseen stress. This is because the stress was defined as pandemic-related and not inflation-driven tightening.

Investment firms are not happy about the emerging consensus in the council, even hawks have returned to the top table. They fear disagreement and hesitation may prove expensive.

“The central bank will hope that it will not need to construct another programme to support Italy,” said Hetal Mehta at Legal & General Investment Management. Italian debt sustainability is in doubt due to higher ECB interest rates, and Italian borrowing costs.

The editor-at-large of finance and markets for Reuters News is the author. All views and opinions expressed are those of the author.

Mike Dolan. Tweet (NYSE):: @reutersMikeD. Charts created by Marc Jones, Sujata Rao and Susan Fenton; Editing by Susan Fenton

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