A Bloc in A Hard Place – The ECB’s Dilemma

The ECB is facing a serious challenge – get inflation under control while avoiding a damaging recession and/or blowing out eurozone bond spreads. Easier said than done.

With inflation running at 8.6% year-on-year in June, historically high debt-to-GDP ratios, and the real chance of a shutoff in Russian gas flows, there is no clear-cut solution for policymakers in Frankfurt:

  • If you raise rates aggressively to fight inflation, you risk rising periphery bond yields and causing serious damage to economic growth.
  • If you do not raise by much, you will see the worst inflation in forty years continue to cut into people’s pockets.

So, what are they going to do? The short answer – muddle through. When there is no good option, you have to pick the least awful. The ECB, from what guidance they have given, have told us they believe this is to raise moderately, stop quantitative easing, and work to create a tool that will deal with the issue of bond market fragmentation. Each step has its own issues.

If They Raise Meaningfully

The ECB is committed to raise by at least 25bps at their July meeting, the first time they have raised rates in a decade. A historic move. Of course, 25bps will do nothing on its own to counter inflation running at 8.6%. Much more would be needed to put on meaningful downward pressure.

Recession Risk From The Potential Cutoff Of Russian Gas

On the day of the July ECB decision (July 21st), the Nord Stream 1 pipeline is due to bring flows back online after scheduled maintenance. However, analysts are sceptical that flows will return to full capacity because of the geopolitics surrounding the war. If pipeline flows do not resume, a key artery feeding European manufacturing will be severed. This coincides with forward-looking economic indicators in Germany flashing red. New export orders are falling significantly, as reported in their PMI. Shockingly, Germany has recorded its first trade deficit since 1991. In its staff economic projections, the ECB forecast a 1.7% decline in GDP in 2023 in the event of a total cutoff of Russian energy supplies.

Will the ECB have the courage to raise aggressively enough to fight inflation in the face of this increased recession risk? The last time the ECB raised rates was in 2011, when then-president Jean-Claude Trichet increased interest rates by 50bps over two quarters. In short order, Portugal’s debt was downgraded to “junk” status by the major rating agencies, Greece had to restructure its sovereign debt, and the ECB had to do an about-face and slash rates even lower than they had initially been before the hikes. Bond market fragmentation looks to be a major obstacle to rate increases this time as before.

Risk Of Bond Market Fragmentation

To deal with the potential for out-of-control bond spreads, the ECB is developing an anti-fragmentation tool. Even though the ECB is yet to raise rates, bond markets have already seen a spike in yields and a significant increase in the spread between German and Italian bonds. Though a large amount of the increase in yields is investor demand for inflation protection, some of the increase reflects the belief of investors that Italian bonds have a higher credit risk than the German equivalent. The spike in eurozone bond spreads, which occurred in mid-June, was followed quickly by an ECB announcement that stated that they would show “flexibility” in reinvesting the redemptions in the PEPP portfolio – i.e., disproportionally buying Italian bonds – and to quickly complete the design of a new anti-fragmentation instrument.

The problem is that member countries spent heavily to keep their economies afloat through prolonged lockdowns. This substantially increased their debt to GDP levels, hurting their creditworthiness. Indeed, all of the new Italian sovereign debt issuance in 2021 was funded by the ECB.

If the ECB is serious about ending QE, then keeping the spread in check will require more than just reinvesting the proceeds of the PEPP portfolio disproportionately in Italian bonds. It may require a new bond-buying program or the equivalent. However, such a move would be politically problematic, with many Germans seeing such programs as undercover transfer payments.

Challenges To A New Bond-Buying Program

Such bond-buying programs may even face serious legal challenges. For instance, in 2020, Germany’s constitutional court called on the ECB to justify that its PPSP bond-buying program was “proportionate” when hearing a case that argued the bank had overstepped its mandate. Though the court ultimately ruled with the ECB finding that it was proportionate, this was only after years of legal wrangling and a vote by the German parliament that stated that the ECB had shown its PSPP programme was justified. Whether the German constitutional court will find such programs are proportionate in future cases is as much a reflection of current German politics as it is a matter of law.

If They Do Not Raise Meaningfully

Second, there is the option not to raise by a significant amount. While this does avoid directly causing an increase in borrowing costs for “peripheral” member states, the inaction looks like an abdication of responsibility. After all, price stability is the sole mandate of the ECB. If it will not step up to the plate when there is a once in a 40-year rise in inflation, when will it?

Finally, if Russia cuts gas supplies this coming winter anyway, this would cause Italy’s economy to sink into a recession and significantly increase their borrowing costs without the ECB having ever taken a hawkish turn.


The ECB is facing a tough set of decisions in its upcoming meetings. There is no easy way to meaningfully put downward pressure on inflation, sidestep the risk of widening eurozone bond spreads, and avoid reducing aggregate demand simultaneously. Each option has a cost. With inflation at multi-decade highs and recession risk looming, the Eurozone is indeed a bloc in a hard place.

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