July 21, 2022, 5:09 am ET Unlike other monetary policymakers, European Central Bank officials have the added challenge of setting 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 interest rates and ending multi-trillion-euro bond-buying programs, it is also trying to prevent government borrowing costs from diverging wildly across the euro zone and hampering the effectiveness of monetary policy. On Thursday, the bank is expected to announce more details on a new policy tool it is designing to stop borrowing costs from rising with a country’s economic fundamentals. These differences between countries are most clearly reflected in government bond yields, a measure of the government’s borrowing costs. Investors will demand higher yields from countries they believe are riskier to borrow, perhaps because of a history of bankruptcy or political instability or slow economic growth. Borrowing costs for Italy, which has one of the highest debts in the eurozone, have risen sharply since the European Central Bank confirmed its plans to raise interest rates. This week, they rose again when the country’s government collapsed, with Prime Minister Mario Draghi resigning on Thursday after key parts of the coalition government abandoned him. The difference, or spread, between 10-year government bond yields in Italy and Germany is now roughly double what it was at this time last year. The European Central Bank considers the sudden break in the relationship between government borrowing costs and fundamental economic variables to be so-called market fragmentation. It said it would not tolerate this as it would reduce the effectiveness of its other monetary policy tools in reducing inflation. It is “crucial that funding conditions move broadly in sync across the euro area when we change our stance,” Luis de Guidos, the bank’s vice president, said earlier this month. “For two equally healthy firms in the euro area, a change in the stance of monetary policy should lead to a similar reaction in their financing conditions, regardless of where they are based.” In late June, the bank announced that from early July it would implement its first line of defense against fragmentation, directing the reinvestment of maturing bond proceeds into its €1.85 trillion (€1.88 trillion) pandemic-era bond-buying program trillions of dollars). in bonds of countries that would better support the objective of its monetary policy cohesion. For example, it can use the proceeds of maturing German bonds to buy Italian debt. At the same time, the bank said it was working on a new tool to stop the generally divergent borrowing costs for some countries. Internal disagreements had to be overcome over the design of this tool to ensure that it did not encourage governments to be fiscally irresponsible in 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 to match the pledge by Mr Draghi, then president of the European Central Bank, to do “whatever it takes” to save the euro It faced many political and legal challenges. Ultimately, the tool, which would have allowed the bank to make unlimited purchases of a country’s debt if the country was part of an official bailout and reform program, was never used. The new tool is expected to come with fewer conditions for a country to benefit from it. See more
