A SAFE PATH to thrill Italian economic policy circles is to raise the prospect of rising inflation. For years, subdued price pressures have been the rationale for the European Central Bank’s super-loose monetary policy. They provided the coverage needed for a range of ECB bond-buying schemes that secretly but effectively bailed out Italy’s huge public debts.
At the moment, nerves in Rome are a bit restless. Annual inflation in the euro zone reached 7.5% in April. ECB the authorities prepared the markets for a possible rise in interest rates as of July. This would require the end of the central bank’s main bond-buying program first. The yield on ten-year German Bunds jumped in anticipation. The same goes for the excess return between the riskiest types of government bonds, notably Italian bonds. constructions, and bunds. Italian bond spreads exceeded two percentage points at the start of the month (see chart).
On the one hand, this rise is eye-catching, but not yet alarming. Italy’s spreads are clearly not out of step with corporate bonds of similar credit rating, given the differences in maturity. Seen from another angle, it is disappointing. After all the efforts over the past decade to make the euro area crisis-proof, a construction behaves not like a bund but like a high-quality corporate bond – with spreads narrowing in times of calm but exploding in times of trouble.
Italy has long been the major weakest link in the eurozone chain. It emerged from the pandemic with a public debt of 151% of GDP, the highest of all major economies except Japan (where inflation is still at rest). Under the right conditions, these debts are manageable. Indeed, if the face value of Italy GDP growth rate can remain higher than the interest rate it pays, the debt burden would decline, as it did last year when the economy rebounded from the recession. Mario Draghi, the former ECB who is now Italian Prime Minister, followed what could be called a “denominator” strategy with regard to the debt-to- GDP report. He tapped the EUa 750 billion euro ($790 billion) pot funded by ordinary bonds, to finance an investment spree with the intention of raising Italy GDP. These funds are conditional on the reforms that Mr. Draghi has set in motion.
Inflation disrupted this strategy in two ways. First, it significantly reduces actual output. The sharp rise in energy prices following the invasion of Ukraine is making Italians poorer and less able to spend on other things. italy GDP decreased in the first quarter. Growth forecasts have been revised downwards. Second, the inflationary shock has led to a global overhaul of monetary policy and widespread risk aversion in financial markets. The widening of Italian spreads is the consequence. With interest rates rising and central banks stopping bond purchases, capital is being rationed more carefully. The safest credits get the first call. The riskiest borrowers get what’s left.
If they hold, higher yields will over time increase Italy’s cost of servicing its debt. Borrowing costs of 3% are not ideal. But Italy has locked in low interest rates on the stock of its existing debt, which has an average maturity of seven years. In the longer term, Italy should be able to manage GDP growth of at least this rate of 3% – 1% real GDP plus 2% inflation, say. Indeed, the current price spike, although deadly for real output, adds to the inflationary part of the GDP.
A big concern is that spread widening is accelerating. Andrew Balls of PIMCOan asset manager, detects a “high point” for construction returns, meaning that when they exceed a certain threshold, they tend to attract more panicked sellers than bargain-seeking buyers, resulting in even higher returns. Concerns about Italian politics are never far from the surface. Mr Draghi is trusted in Berlin and Brussels, but he must step down before the elections next spring. He may not even last that long as cracks appear in his coalition over the war in Ukraine.
In these circumstances, the instinct is to turn to ECB to check for widening spreads. But with inflation where it is, the central bank’s continued use of tools like negative interest rates and asset purchases seems inappropriate, hence the scramble to ‘normalize’ monetary policy. . However, inflation seems less entrenched in the euro zone than in America, for example. Wage growth is still quite modest, for example. The ECB, therefore, they may not have to raise interest rates as much as financial markets anticipate. The nervous technocrats of Rome will cross their fingers.
Learn more about Buttonwood, our financial markets columnist:
Who wins carnage in the credit markets? (May 7)
Slow pain or fast pain? The Implications of Low Investment Returns (April 30)
A Requiem for Negative Government Bond Yields (April 23)
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