Unlike other monetary policymakers, the officials at the European Central Bank have the extra challenge of setting one policy for many different countries, each with its own fiscal policy, economic outlook and debt level.
As the bank tightens its easy-money policies by raising rates and ending its multitrillion-euro bond-buying programs, it is also trying to prevent government borrowing costs from diverging wildly across the eurozone and impeding the effectiveness of monetary policy.
On Thursday, the bank is expected to announce more details of a new policy tool it is designing to stop borrowing costs rising out of sync with a country’s economic fundamentals.
These differences among countries are most clearly reflected in sovereign bond yields, a measure of government borrowing costs. Investors will demand higher yields from countries that they believe are riskier to lend to, maybe because of 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 reaffirmed its plans to raise rates. This week, they surged again when the country’s government fell apart, with Prime Minister Mario Draghi resigning on Thursday after key parts of the coalition government abandoned him. The difference, or spread, between 10-year sovereign bond yields in Italy and Germany is now roughly 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 economic fundamentals to be so-called market fragmentation. It has said it won’t tolerate this as it would reduce the effectiveness of its other monetary policy tools to bring down inflation.
It is “critical that financing conditions move broadly in sync across the euro area when we change our stance,” Luis de Guindos, vice president of the bank, said earlier this month. “For two equally sound firms in the euro area, a change in the monetary policy stance should lead to a similar reaction in their financing conditions, no matter in which country they are domiciled.”
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 steering the reinvestments of proceeds from maturing bonds in its 1.85 trillion euro ($1.88 trillion) pandemic-era bond-buying program to bonds of countries that would best support its monetary policy goal of consistency. For example, it might use the proceeds from maturing German bonds to buy Italian debt.
At the same time, the bank said it was working on a new tool to stop broadly diverging borrowing costs for some countries. Internal disagreements needed to be overcome about the design of this tool to ensure that it didn’t encourage governments to be fiscally irresponsible under 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 tried to design a policy tool that would match the commitment by Mr. Draghi, then the president of the European Central Bank, to do “whatever it takes” to save the euro. It was met with many political and legal challenges.
In the end, the tool, which would allow the bank to make unlimited purchases of a country’s debt if the country was part of a formal bailout and reform program, was never used.
The new tool is expected to come with fewer conditions for a country to benefit from it.