Every nation in the world has a common enemy at the moment. Russia seems to be the best guess because of its invasion of Ukraine, but people following the financial and economic world know there lies an even bigger threat. Lurking around the shadows and becoming larger day by day, inflation is causing a lot of trouble in various parts of the world. It’s understandable that Russia has played a big part in what constitutes most of it since Brent Crude prices have skyrocketed, but stimulus packages post covid also have a role to play in this matter. Cheaper credit to boost business growth to revive the economy has come back to haunt the same thing it tried to save a couple of years later. Major world economies have all taken steps to combat inflation. The U.S Fed has recently increased the interest rates by 0.75 basis points (1 basis point is 1/100 of 1 %), the RBI raised the repo rate by 0.50 basis points and the EU also has some plans to fight the rising inflation in countries like Italy.
The European Central bank (ECB) held an emergency meeting on Wednesday, the 15th of June to discuss the current market conditions as the bond yields were rising rapidly in many countries. An increase in bond yields usually pertain to an increase in growth or higher inflation. In this case, a higher inflation is more likely to be the cause of the increase. The 10-year bond yield in Italy rose to a high of about 4.2%, and the yield spread between the 10-year German and Italian bonds, which is used by many investors to understand the market situation, widened to its highest margin since 2020. The bond yields were moving up due to a consensus that the central bank would increase interest rates as the Consumer Price Index (CPI) has been increasing steadily. Right after the announcement of the meeting, the bond yields dropped down and the Euro rose in value against the U.S dollar. The shares of some Italian banks (Banco Bpm) too rose in value. The head of the ECB, Christine Lagarde, had announced to the press that the bank plans to increase its key interest rate by 25 basis points during its July monetary policy meeting. Consequently, an increase in interest rates in September is also expected and depends on how the inflation situation pans out. This was considered as good news by many investors to rein in inflation but will pose a problem to highly indebted nations (Italy, Spain) as the cost of their debt increases. There also lies the risk of market fragmentation, where bond spreads between the European countries widen without any real economic factor backing or supporting the increase. This could lead to a bad investor sentiment and may influence the interest rates for that specific country in the future. Different financing conditions in different countries is why fragmentation is used as a term here.
With the EU having so many different countries having different fiscal policies but a single monetary policy, it is very tough to know for sure whether it will come out unscathed from this ordeal. The ECB, in an effort to fight fragmentation, said that it would use the proceeds from its bond buying program (PEPP) to reinvest in different areas and asset classes. This is only an initial response to fragmentation worries and the bank will come up with more solutions in the near future. Overall, the situation is grim, but the ECB seems to be confident in its abilities to overcome this ordeal. Only time will tell how well the policies of the bank will provide or perform.
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