"The European Central Bank is treading on risky ground"
The European Central Bank (ECB) has raised interest rates by 0.5 percentage points at its latest meeting, marking the first increase in eleven years. This move is not aimed at tightening the economy, but rather at normalizing interest rates, taking its foot off the gas, not hitting the brakes.
The step to raise interest rates is late, but necessary, according to the ECB. Clemens Fuest, head of the Ifo Institute, supports this decision. However, the potential risks for heavily indebted EU countries like Italy are significant.
The increased ECB rates could lead to increased debt servicing costs for Italy, straining public finances, raising borrowing costs, and heightening risks of fiscal instability or default. Higher interest rates make refinancing existing debt more expensive, worsening fiscal deficits and potentially leading to loss of investor confidence if market participants doubt Italy's ability to manage debt sustainably.
Italy, with its high public debt, faces the risk that higher ECB rates will increase the cost of new debt issuance and debt rollovers. This raises the risk of budgetary pressures, forcing Italy to allocate more resources to interest payments rather than public investment or social programs. As a result, reduced fiscal space could lead to austerity measures, slower growth, and difficulty in meeting debt obligations, increasing the possibility of a sovereign debt crisis.
However, some relief from further immediate rate increases has been provided as the ECB has paused interest rate hikes after a series of rate cuts since 2024. The ECB's stance remains data-dependent, with monetary policy adjustments contingent on inflation outlook and economic conditions. This implies future rate hikes remain possible and could renew pressure on sovereign debt burdens in vulnerable countries.
Inflation in the Eurozone reached a record level of 8.6 percent in June and 8.9 percent in July, driving up tax revenues and reducing the real value of the public debt in Italy. However, the overall risk of sovereign debt stress persists if rates rise again or economic growth falters.
Clemens Fuest criticizes the ECB's new bond-buying program, arguing it could endanger the ECB's independence and set the wrong incentives for financial and economic policy. The ECB's toolkit and complex interest structure are still capable of curbing the current inflation, but its effectiveness will be clear in the coming months.
For now, the era of nominal negative interest rates is over, but real interest rates are still deeply negative. Higher interest rates will take time to fully impact the public finances of heavily indebted EU countries like Italy. Italian government bonds have an average maturity of seven years.
It's difficult to estimate the neutral interest rate level given the current situation marked by high uncertainty. The order of exiting bond purchases before negative interest rates was important, but bond purchases should have happened earlier. If a recession is caused by a decrease in goods supply, it may not be appropriate for monetary policy to boost demand through interest rate cuts.
The ECB's new bond-buying program is intended to prevent a divergence of financing costs of EU countries. The conditions for a country to participate in the program are significantly weaker than those of the bond-buying program OMT introduced during the Euro crisis. The ECB has not ruled out the possibility of reintroducing negative interest rates in future situations with low inflation.
In summary, the main risk from ECB rate hikes for heavily indebted countries like Italy is the increased cost of debt servicing and rollover, which can exacerbate fiscal imbalances, reduce growth, and raise default risk. While the current monetary policy pause provides some temporary respite, the overall risk of sovereign debt stress persists if rates rise again or economic growth falters.
[1] Source: ECB Official Press Release [2] Source: Financial Times [3] Source: Reuters News Agency
1) The raised interest rates by the ECB could negatively affect the financial situation of heavily indebted EU countries like Italy, potentially leading to increased debt servicing costs, straining public finances, and raising borrowing costs.
2) The potential risks for Italy, with its high public debt, are significant due to the increased ECB rates, as it could result in increased costs of new debt issuance and debt rollovers, exacerbating fiscal imbalances and heightening default risk.
