How will the eurozone cope with higher rates?

Higher interest rates have sent government borrowing costs soaring. In the UK, 10-year gilt yields have risen from less than 1 per cent two years ago to over 4 per cent today. This increases the cost of new borrowing – a headache for a government looking to win over voters before a general election. But the impact of higher interest rates on government finances might be even more painful in the euro area. 

Although inflation in the euro area now averages around 2.5 per cent, there are huge variations. The annual rate of consumer price index (CPI) inflation was -0.7 per cent last month in Belgium, but at the same time was running at 7 per cent in Slovakia. The trouble with the one-size-fits-all approach that the European Central Bank (ECB) must take is that it can all too easily end up fitting none.

Things are made even more difficult by the fact that member states also have different tax and spending programmes – and different levels of indebtedness as a result. Italian debt stands at 140 per cent of gross domestic product (GDP), compared with roughly 70 per cent in Germany, and only 20 per cent in Estonia. Higher government borrowing costs are more of a problem for some economies than others, meaning that higher ECB interest rates do not trigger an even rise in government bond yields.

The chart shows that the spread between the yield on 10-year German and Italian government bonds started to widen as rates rose, reaching almost 2.5 per cent in September last year. This prompted fears of the kind of ‘fragmentation’ seen in the eurozone crisis, where concerns about the future of the bloc saw huge flows from riskier peripheral bonds to safer sovereigns. If we do enter a period of ‘higher for longer’ interest rates, could the same thing happen again? 

Goldman Sachs analysts think that spreads have become less sensitive to policy changes since the summer. The gap between 10-year German and Italian bond yields closed sharply, thanks in part to the ECB’s new anti-fragmentation tool, which sees it buy more debt issued by 'periphery' nations. This all looks positive – but analysts warn that it could also mean that rates need to stay higher for longer.

Goldman thinks a more muted correlation between policy rates and sovereign spreads points to a higher interest rate peak to ensure that inflation returns to the ECB’s 2 per cent target. Their models suggest that the interest rate will need to be held at around 2-2.5 per cent over the longer term – meaning that rock-bottom policy rates could be firmly consigned to the past. 

The end of ultra-loose monetary policy will be a shock. According to Jacques de Larosière, former director of the French Treasury and managing director of the International Monetary Fund (IMF), years of cheap borrowing disincentivised economic reforms – and Europe is still dealing with the consequences today. In an article for the OMFIF think tank, he said that although quantitative easing helped with problems caused by widening bond spreads, it also “heightened general indebtedness and vulnerability of the financial system”. 

As a result, bond spreads could widen once more. De Larosière warns that because of different fiscal and structural policies, spreads will “sooner or later” reappear. The ECB might not be able to do much about it. Structural problems, after all, run far deeper than monetary policy. De Larosière said that “central banks are not obliged to erase systematically all traces of interest rate differences”. 

In October, ECB economists stressed the importance of reforms such as cutting regulation and lowering debt to GDP ratios in helping weaker European economies to catch up. By levelling the playing field, the impact of higher interest rates should be felt more evenly across economies – reducing the risk of fragmentation in the future. But this is no quick fix. French president Macron lamented earlier this year that “it is hard enough for Europe to advance on sensitive topics with 27 members”, and warned that the EU couldn’t enlarge without reform. This all means that the impact of higher rates will continue to be felt asymmetrically.