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On Thursday, the ECB’s Governing Council acted more or less as expected. Inflationary pressures have widened and intensified, justifying a shift in rates. As it is good practice to start incrementally, President Lagarde announced a 0.25% increase in the policy rate for the next meeting on July 21 and promised a further 0.50% increase in September should medium-term inflation projections remain above the 2% target, which seems likely. And the uptrend will continue over the next few months. But what focused financial markets’ attention on Thursday was the absence of specific indications on the so-called ‘anti-spread shield’ or how the ECB intends to prevent a possible fragmentation in the transmission of monetary policy. In December, the central bank announced a flexible reinvestment of the purchased securities under the pandemic-related program (PEPP). However, many important details have deliberately not been revealed yet.

In essence, the strategy of so-called ‘constructive ambiguity’ prevailed, that is to say and not to say, with the promise that the central bank would do everything necessary. But in these cases, the credibility of the commitment counts. Not only does President Lagarde not seem to enjoy the same magic as Draghi in the eyes of financial markets, but recent statements have made it clear that the Governing Council is divided on this issue. In fact, it is no secret that many national governors are unwilling to go beyond what is already foreseen under the OMT, which is an ECB intervention granted only under specific conditionality approved by the European Council. Understandably, they want to avoid the so-called fiscal dominance, that is, being forced to act not to safeguard price stability but to save countries in difficulty. Therefore, the cold gust of northern wind felt at Thursday’s meeting in Amsterdam was not surprising. But on the other hand, Europe has already shown solidarity with Next Generation EU, and it would be at least bizarre for it to inflict another financial shock on itself for not wanting to act promptly.

Mark Twain said that historical events do not repeat themselves but often rhyme. In fact, it seems that the euro area is fast approaching a perfect storm, which has similarities with the situation in 2011. Let me put all the elements in a row. First, there is very high uncertainty about the economic prospects linked to energy and raw materials costs and thus to war. And this comes after an unprecedented shock like the pandemic. In 2011 there was the aftermath of the 2008-09 global financial crisis. Second, there is a turning point in the international financial cycle, triggered by the change in the direction of US monetary policy in 2021 and then by the ECB. In 2011, the ECB had raised rates twice before reversing course. Finally, let’s not forget that increasing risk premium, and thus yield spreads, is part of any monetary tightening.

Banks in the euro area should benefit from the rise in interest rates. It is odd, however, that their performance in the stock market did not react accordingly, leaving some doubts about their ability to continue to finance the euro area economy adequately and homogeneously. Furthermore, emerging countries that do not produce raw materials and energy are in great pain. More than half of those who benefited from the G20 suspension of interest payments on debt are now de facto insolvent and will face a restructuring of their debt sooner or later. At least initially, this will also increase the perception of risk in the euro area. Finally, rating agencies have adopted a very conciliatory attitude, which could change soon. If we add that Italy has important elections around the corner, increasing the perception of political risk, the mixture can become explosive.

Therefore, it is not unthinkable that financial markets will want to test ECB’s resolve at some point, and this may happen sooner than one might imagine. How do we get out of this situation then? It becomes essential that a protective umbrella of a monetary or fiscal nature is activated immediately to prevent possible financial stability and fragmentation problems rather than alleviate them ex-post.

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