The ECB will have to temper its toughness

The ECB raised interest rates more sharply than previously indicated. The central bank is behind the curve on inflation as it juggles a series of problems – with Italian politics now even more problematic for EU policymakers.

| 7 min read

The European Central Bank (ECB) raised its benchmark interest rates by 50 basis points (bp) to combat inflation at its July meeting, a larger move than it had previously signalled (25bp). It is the central bank’s first rate rise in 11 years. In one move, the ECB has ended the era of negative interest rates, bringing its deposit rate – what banks receive for depositing money overnight with the ECB – to zero from minus 0.5%.

The ECB appears to have been slow to act on inflation, lagging other major central banks in raising rates. However, the central bank faces numerous serious issues that others do not. These include a winter gas issue as Vladimir Putin threatens to weaponise European supplies over Ukraine, an industrial crisis in Germany as the car industry undergoes a period of rapid change – and mounting political opposition to the EU project itself in some peripheral EU states.

The resignation of Mario Draghi as Italian prime minister just before the ECB made its announcement is yet another headache for the central bank. In recent weeks, the ECB has become very worried about the gap between the borrowing costs of heavily-indebted countries such as Italy and Greece in the south, and the lower long-term borrowing costs of Germany, Austria and the Netherlands at its core.

Different economies, one interest rate

The central bank sets the same short-term interest rate for the whole zone and wants greater uniformity of longer-term borrowing rates around the region. Instead, past German insistence on each country in the zone needing to run its own prudent budget to retain a good rating in the global bond markets has left state debts vulnerable to adverse market movements when a government is thought to have weak finances.

The pressures on Italy have just got worse thanks to mounting instability in Italian politics, with the country’s bonds sold off sharply once more after Mr Draghi tendered his resignation for a second time just before the ECB unveiled its decision. Mr Draghi, who once famously saved the euro from a worse crisis as President of the ECB when he promised to do “whatever it takes”, had been co-opted as Prime Minister to hold together an unstable coalition of parties elected in 2018 to the Italian parliament.

The pressures on Italy have just got worse thanks to mounting instability in Italian politics.

The populist 5-Star party romped to first place in that election, with 32% of the vote, taking 227 seats in a 630-seat Chamber of Deputies. It joined with the traditional centre-left party, the Democratic party, in a coalition government which also brought in Forza and Lega from the right to create a very strong voting block of all the main parties that were elected to seats in 2018.

This coalition has pursued a determined pro-EU line in defence of Italy receiving the largest country share of the EU post-Covid recovery funds, which totals some €200bn. By being loyal to the coalition 5-Star has lost plenty of support, with its latest opinion poll ratings languishing in the 9%-to-12.5% range. It has chafed at the policy of sending arms to Ukraine, preferring to help seek a negotiated peace with Russia. It has complained that support for those on lower incomes to tackle the cost-of-living crisis has not been sufficient – and it wants to see a higher minimum wage.

Last month, the strain on 5-Star led to a split. The Foreign Minister took 60 5-Star MPs and Senators with him to form a new group called “Together for the future”. Their break point was 5-Star’s reluctance to back the EU stance on weapons for Ukraine fully.

A more anti-EU coalition in prospect?

Meanwhile, Brothers of Italy, which attained just 4.4% of the vote in 2018 with 32 seats, has leapt to first place in opinion polls with a rating of around 23%. It stayed out of the grand coalition and has been a running critic of the government as it has become more unpopular. Within the coalition, Forza and Lega have held more of their 2018 vote – although it is still down. It has more in common with the Brothers – and might be up for an earlier election to seek a right-of-centre more Eurosceptic coalition government.

5-Star had been indulging in brinkmanship with Mr Draghi, trying to force changes to policy over Ukraine and the cost of living. Many members of the Italian Parliament may end up their seats in an election. Not only have the well-represented parties in Parliament (with the exception of the Democratic Party) become much less popular, but a recent referendum has required the next Parliament to have just 400 seats in the Chamber of Deputies compared to the current 630, with 200 seats in the Senate compared to the current 315.

Markets thought Italy’s government could stumble through to an election next spring, delaying a bruising encounter between some of the governing parties and the electors. The more the government can harness the EU monies and generate some recovery the better from the governing parties’ point of view. Today that does not look so likely, and Italy’s new government may be much more Eurosceptic than the one led by Mr Draghi.

Muddling through may be a challenge

Meanwhile, as elsewhere in Europe, Italy wrestles with soaring energy costs, gas shortages and a shortage of rainfall too. The ECB needs to balance all this and will want to find a way to buy more Italian debt to contain the widening of spreads between German and Italian interest rates. The wider EU will be straining to offer more financial support to lagging member states, as it seeks to integrate its varied economies more closely. The three right-of-centre, more-Eurosceptic parties are well placed to lead the next government of Italy on current polls, which would introduce more friction into the EU relationship.

The ECB tried to temper future expectations in its statement alongside the rate rise.

The ECB’s three main aims of cutting inflation, propping-up peripheral bonds and avoiding a recession are difficult to reconcile. They will hope to muddle through without taking aggressive action on rates the Fed has chosen. Indeed, the ECB tried to temper future expectations in its statement alongside the rate rise.

“The frontloading today of the exit from negative interest rates allows the Governing Council to make a transition to a meeting-by-meeting approach to interest rate decisions,” the ECB said. “The Governing Council’s future policy rate path will continue to be data-dependent and will help to deliver on its 2% inflation target over the medium term.”

The ECB needs to show it is being tough on inflation without being so tough it tips some EU member states into recession. Mario Draghi’s resignation may have just made a tough job tougher.

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The ECB will have to temper its toughness

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