Sun sets over the skyline and ECB headquarters in Frankfurt
European Central Bank (ECB) headquarters building is seen during sunset in Frankfurt, Germany, January 5, 2022.

The European Central Bank's 'whatever it takes' commitment to bind the euro zone is wearing thin as it tries to 'normalise' monetary policy and give inflation hawks more say in how it goes about it.

Warning that inflation is unacceptably high and that it would remain above the 2% target over a three-year forecast horizon, the ECB on Thursday flagged a first interest rate rise in more than 10 years next month, after the end of new purchases on its long-running bond-buying programme from July 1.

Although ECB chief Christine Lagarde stressed that the central bank was 'committed' to avoiding so-called 'fragmentation' of borrowing costs between euro zone members as bond buying ends, financial markets were far from sure.

Many investors doubt Lagarde's developing approach to ECB policymaking - which appears to give greater voice to national central banks and countries with a more hawkish monetary stance that those at the centre - will allow the same sort of open-ended commitment to rein in debt costs at the periphery as given by her predecessor Mario Draghi.

Draghi's seminal 'whatever it takes' comment in a London speech in 2012 was credited with ending the existential two-year euro debt crisis back then. Now as Italian Prime Minister, he may have good reason to worry those words don't appear to be resonating as much with markets 10 years on.

Italy's government bonds, the second biggest euro government debt market by size and a bellwether for sentiment toward high-debt euro sovereigns at large, plunged after Thursday's announcements as both Italian nominal yields and those relative to benchmark German equivalents ballooned.

As futures markets priced a whopping 1.2 percentage points of further ECB hikes between the pre-announced July rise and year-end, Italy's 10-year bond yield rose as much as 20 basis points on the day to its highest level since 2018 at 3.715% and just a whisker from eight year-peaks.. Spanish, Portuguese and Greek yields all wobbled too.

As worrying, the risk premium on Italian 10-year bonds over Germany's moved to 225 bps - its highest since the onset of a pandemic that forced multiple fiscal rescues and pushed Italy's debt to a record 160% of gross domestic product.


Speaking at Amundi's World Investment Forum in Paris as the ECB met, former International Monetary Fund chief economist Olivier Blanchard said he worried the ECB did not yet have the sort of tools that will convince investors fragmentation is manageable.

Blanchard reckoned that the sort of monetary tightening the ECB was likely to need to control inflation was less than was required by the U.S. Federal Reserve - as labour markets were much tighter in the United States and therefore ECB tightening shouldn't in theory be a problem for debt sustainability.

But he said bond investors still needed to be convinced of that because an outsize rise of long-term borrowing costs could by itself change those sustainability metrics and create a "self fulfilling" problem the ECB would eventually need to address.

"My main worry about the ECB is that in order to convince investors that the spread will remain low you have to convince them you will do whatever it takes," said Blanchard, now a senior fellow at Peterson Institute for International Economics.

"If investors believe you will put a bit in, but not enough, they will still demand a higher spread," Blanchard said. "I'm worried at this stage that the ECB doesn't have a process with which it can intervene sufficiently to address this and I suspect this is going to be an issue for the next year or two."

As the ECB announced the end of its Asset Purchase Programme, introduced in 2014 to avert potential deflation, Lagarde insisted the central bank had the flexibility to deal with any fragmentation that followed.

"If it is necessary, as we have amply demonstrated in the past, we will deploy either existing adjusted instruments or new instruments that will be made available," Lagarde told a news conference. "But we are committed - committed - to proper transmission of our monetary policy."

But "proper" is a fuzzier concept when you are tightening underlying monetary policy - unlike the 2012-14 period when easier and easier policy jibed with the underlying deflation picture. Similarly, the objection in the ECB statement to "unwarranted" fragmentation remains ill-defined in many eyes.

What's more, ECB sources told Reuters after the meeting that there was a large majority of policymakers against announcing a new fragmentation-fighting tool this week.

The prospect of using the proceeds of coupons and or maturing bonds bought through the separate Pandemic Emergency Purchase Programme (PEPP) in the event of any new stress also seems to be caveated by defining that stress as strictly pandemic-related - and not emanating from inflation-driven tightening per se.

All in, investment firms seem uncomfortable about the evolving consensus within the council if hawks are back at the top table and believe disagreement and hesitation could be costly.

"The central bank will hope that it will not need to construct another programme to support Italy," said Hetal Mehta at Legal & General Investment Management. "Higher ECB interest rates and Italian borrowing costs call into question Italian debt sustainability."

The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own.

(by Mike Dolan, Twitter: @reutersMikeD. Charts by Marc Jones and Sujata Rao; Editing by Susan Fenton)