A new mix of ECB hiking supported by the financial aid Augle Bumpy era

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European governments and central banks are moving towards a combination of economic policies not seen before the global financial crisis, which could open up a new era of fretting on markets.

Capital is acting to support demand through an expanded budget as the European Central Bank is considering raising interest rates in July to calm inflation.

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However, as governments intervene for more help, central banks can curb the stimulus, but higher borrowing costs will ultimately strain the finances of countries such as Italy.

How long the mix can last depends on the willingness of investors to keep funding the debt-bearing government, the ECB’s determination to combat inflation, and its ability to keep the market under control.

Economists such as Gilles Moec, chief economist at AXA Investment Managers in London, suspect that the new fiscal and currency combinations in the euro area could be overkill.

“In principle, this frees up space for faster normalization by the ECB, but there are limits,” he said. “The test is what the market accepts in terms of fiscal stimulus, which is no longer backed by special monetary policy.”

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Evaluating proper financial and fiscal balances will be an issue for Eurozone finance ministers and central bankers meeting with Group of Seven counterparts this week in Bonn.

The ECB has not yet participated in the global tightening already enacted by peers from the Federal Reserve Board to the Bank of England, but the rate hike cycle begins in July to combat record inflation. Stars are adjusting in Frankfurt for the Eurozone.

This is the month that policymakers increasingly quote in their first move, and last week there was a signal from ECB President Christine Lagarde himself.

Meanwhile, the government stays firmly in the stimulus mode they first started during the pandemic. The euro area recorded a total budget deficit of about 7% and 5% in 2020 and 2021, respectively. The region was initially planned to comply with the European Union’s debt limit cuts as of next year, but it is unlikely now after the outbreak of the war in Ukraine. ..

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In addition to reducing the inflationary burden on households and businesses, the government is also facing greater investment needs to cut off Russia’s energy and strengthen its defenses. According to UBS economists’ analysis, costs will be 2% of economic output by the end of next year, most of which will be paid in 2022.

So far, loose monetary policy has supported such large scales, keeping government borrowing costs down by both maintaining ultra-low interest rates and buying bonds. The purchase of emergency debt has already stopped, and the overall quantitative easing is about to stop altogether.

Sylvia Aldagna, an economist at Barclays in London, said: “The desire of investors to absorb higher issuance levels is certainly price sensitive.”

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The market reaction was the sold out of Eurozone bonds, with Germany’s 10-year yield reaching 1% for the first time since 2015. The premiums above that level that investors demand to hold Italian debt have risen to their highest levels ever since. The early months of the pandemic were about 200 basis points.

If bond yields in the weak eurozone economy plummet, ECB staff have been working on a crisis tool to develop what may eventually be necessary for Bloomberg economics calculations.

In any case, according to Barclays’ Aldagna, it may also be necessary to consider emulating a pandemic-era plan to support finances by pooling borrowing at the EU level.

Morgan Stanley economists have warned that the long-term nature of sovereign debt provides some insulation, so it may take some time for government pressure to materialize. In a report last week, they emphasized that the ECB’s suspension of bond purchases and imminent rate hikes will only affect the “long term.”

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Moody’s Investors Service said in November that interest payments as a percentage of GDP averaged 1.3% this year and next in Western Europe, significantly lower than the 10-year average before the pandemic.

Still, Bank of France Governor Francois Bilroy de Garhow last week raised the prospect that higher interest rates would ultimately put pressure on the government to strengthen public finances.

“Our board will act as much as we need to,” he said. “Therefore, it is becoming increasingly important for fiscal authorities to ensure debt sustainability in the context of rising interest rates. This will begin and dominate in the coming years.”

The Bank of France estimates that after 10 years, a 1% increase in tariffs will incur additional costs of nearly € 40 billion ($ 42 billion). This is about the same as the national defense budget.

Given the market risk lurking in the euro area, whether the ECB has a high degree of freedom to tackle inflation is an open question in itself.

Ludovic Subran, Chief Economist at Allianz SE, said: “It’s hard to imagine a scenario where central banks can really hike the way they want.”

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