Earlier this year, sky-high inflation forced the Federal
Reserve to slam on the monetary policy brakes. The same now appears to be
happening in Europe, where the European Central Bank (ECB) is being forced to
reverse course to contend with inflation at the highest level since the Euro’s
1999 launch.

The ECB’s monetary policy shift does not bode well for
global financial markets. In much the same way as the Fed’s more hawkish
monetary policy stance has led to a sharp correction in the US equity and
credit markets, the ECB’s policy shift now risks reigniting the Eurozone
sovereign debt crisis.

It would be a gross understatement to say that financial
markets have not received well the Fed’s announcement that it plans to raise
interest rates in 50-basis-point steps at its next two meetings. Nor have they
warmed to the idea that soon the Fed will be removing as much as $95 billion a
month in liquidity from the markets by not rolling over the bonds it holds at
maturity.

Since the start of the year, not only has the stock market
now declined by around 20 percent. The bond markets, too, have fallen by a
similar amount while the cryptocurrency market has fallen by 50 percent and
emerging market spreads have widened markedly.

The net upshot is that around $12 trillion, or 50 percent of
GDP, in US household wealth has evaporated. This is bound to cause these
households to tighten their belts in an effort to rebuild their savings. That
is the last thing that the US economy needs at a time when the Biden fiscal
stimulus is fading, high mortgage rates are causing housing demand to crumble,
and a strong dollar is making it more difficult to export.

Now it is the ECB’s turn to make a major policy shift to
deal with inflation. Earlier this week, Christine Lagarde made clear that by
the end of September, the ECB will have put an end to its long-standing policy
of negative interest rates. More significantly yet, she underlined that it
would also end its hitherto aggressive bond buying programs.

The main risk that the ECB’s policy U-turn now poses to
global financial markets is not so much that it will no longer be adding to
global financial market liquidity with its bond buying activity. It is rather
that the ECB will no longer be there to buy on a massive scale the bonds issued
by the Eurozone’s periphery governments in general and by the Italian
government in particular.

Over the past two years, the COVID-19 pandemic has done
serious damage to the economic periphery’s already shaky public finances. As an
example, in Italy, the Eurozone’s third-largest economy, the budget deficit
ballooned and the public debt to GDP ratio skyrocketed from 135 percent before
the pandemic to 150 percent at present.

Despite their dubious ability to grow their way out from
under their debt mountains while stuck within a Euro straitjacket, the economic
periphery’s governments have had no difficulty financing themselves at record-low
interest rates. This was largely due to the fact that the ECB used its Pandemic
Emergency Purchase Program to buy up almost the entirety of those government’s
debt issuance.

With the imminent end of all of the ECB’s bond buying
programs and with scheduled Italian parliamentary elections next year, the
question has to be asked as to who will now be covering the Italian
government’s estimated EUR700 billion annual gross financing needs. As if to
underline this point, in anticipation of the end to the ECB’s bond buying
programs, the Italian government bond spread with respect to Germany has more
than doubled to around 215 basis points or to a similar level immediately
preceding the pandemic.

In 2010, the Greek sovereign debt crisis shook world financial markets. Now that those markets are already under strain as a result of Fed tightening, the last thing that we need is a sovereign debt crisis in Italy, a country whose economy is some 10 times the size of Greece’s. Yet, if the European economy succumbs to another recession as a result of ECB monetary policy tightening, that is what we should be expecting to happen.

The post Farewell to Easy European Money appeared first on American Enterprise Institute – AEI.