Author, Former Head of the European Department of the International Monetary Fund, Chief Economic Advisor of Morgan Stanley

after another hate Inflation surprise Financial markets received information last month that policy tightening was underway as ECB President Christine Lagarde no longer ruled out a rate hike in 2022. Long-term rates have started to rise across the euro area, especially in Italy and Greece, where risk spreads have risen to their highest levels since the outbreak (165 and 230 bps, respectively).

While it is right that interest rates should rise to cool demand and prevent high inflation from becoming entrenched in expectations, the process could prove messy. That’s because the European Central Bank, which meets this week, has repeatedly said it will not raise policy rates until it ends its sovereign asset-purchase program. Officially, the program has no end date. In reality, however, the ECB began tapering its purchases this month, and markets have sensed that a plan to support low and stable bond spreads since 2015 will end in early summer.

Given the current low levels, there is certainly room for interest rates and spreads to rise. But it’s also important to limit spreads in some way — not least because their spikes and volatility hinder the transmission of monetary policy across the euro area.

As things stand, there are three paths to monetary tightening.

First, the ECB could quickly complete asset purchases, accept higher long-term interest rates and spreads, and tighten financial conditions; near-term policy rates could be raised shortly thereafter. The strategy can work — but only if another pillar of European stability — Mario Draghi, the leader of Italy’s government of national unity, remains in place. A change in circumstances could easily lead to a spike in spreads in many peripheral countries.

Second, the ECB could abandon the self-discipline that quantitative easing must end before interest rates rise. The rationale for this ordering is that higher interest rates shrink demand, while continued asset purchases stimulate demand – so pursuing both would send conflicting economic and market signals, like one foot hitting the brakes and the other the other. Just like stepping on the gas pedal.

Concerns about mixed signals and uncertain macroeconomic implications are overblown. On the one hand, the ECB will raise policy rates from negative levels, which may have only a limited impact given banks’ traditional reluctance to pass these rates on to retail savers, so shouldn’t be very disruptive at first. Since then, nothing has stopped the ECB from calibrating rate hikes and asset purchases so that the net effect is contractionary. Modest asset purchases, such as EUR 20 billion to 30 billion per month, may be sufficient to maintain stability in bond markets while allowing for a net tightening of monetary conditions. It is not unheard of for central banks to engage in opposing trades of short- and long-term assets: the Fed has done so more than once. Operation Twist.

Third, euro area governments can relieve the ECB of the burden of controlling sovereign spreads. The most immediate approach would be to create a centralized financial mechanism, such as the EU’s Coronavirus Recovery Fund, to provide loans and grants to member states facing temporary difficulties. While the ECB is credited with keeping sovereign spreads low and stable during the pandemic, much of the credit goes to the Recovery Fund, a more tangible sign of European political and economic solidarity than the ECB’s emergency action could. more to offer. Access to such a facility must have some safeguards. But the conditions shouldn’t be as onerous as the adjustment program required by the ECB’s direct currency trading facility, a political loser in countries like Italy.

This option is the most economically sensible, both to meet the needs of near-term monetary tightening and to address long-term gaps in the euro area’s financial architecture. It also has the benefit of separating monetary considerations from financial stability concerns, allowing the ECB to focus on its core inflation mandate.this Upcoming Reforms The Stability and Growth Pact is an opportunity to achieve a centralized fiscal mechanism, possibly with stricter standards of fiscal integrity if member states so wish.

While the case for monetary tightening is becoming more pressing, the best economic solution is currently not politically realistic. In this case, the ECB should abandon its current guidance on the sequence of monetary tightening. The worst it could do is ignore political and economic realities and just go full steam ahead, end asset purchases and raise the ECB’s policy rate.