The ECB's change in rate hikes reinforces fears of a new bond crisis

European Central Bank policymakers gathered in Portugal on Monday with a sinking feeling that their push to deal with an inflation shock they failed to predict risks both a recession and echoes of the euro zone sovereign debt crisis.

When President Christine Lagarde and her colleagues meet at the resort of Sintra for their version of the Federal Reserve conference in Jackson Hole, they face competing challenges: to cool the fastest rise in consumer prices in euro history without causing a 2012-style economic downturn or surge in borrowing costs in Italy, the region's third-largest economy, and other vulnerable states.

Markets have already sounded the alarm about what may lie ahead. Italian government bond yields jumped above 4% this month for the first time since 2014 as investors thwarted the ECB's plan to raise interest rates in July for the first time in a decade.

With that increase recorded and another due in September, officials are rushing to deliver on their promise of a deployment tool if yields do rise.

"The ECB is in a big trouble," said Charles Goodhart, a former Bank of England politician. "They can't normalize very quickly – loading interest rate hikes in advance – without addressing the fragmentation problem."

Inflation is now four times the ECB's 2% target, and Lagarde gave a glimpse of a recent introspection last week, telling European lawmakers that officials "misjudged certain factors that had a major impact on inflation." 

Fluctuations in rate hikes, as the Fed and others have done, have been a matter of confidence related to earlier recommendations that have since become obsolete, she said.

While the ECB is currently on the verge of reversing rates below zero, the turnaround is being tested by the worst sell-off in recent years of bonds of eurozone governments. As large-scale purchases of the bank's assets end on Friday, policymakers are trying to develop support to help rein in yields as their push for monetary policy normalization shifts the gear.

The Sintra Forum, which kicks off tonight, has traditionally been conceived as a relaxed event, allowing policymakers and academics to reflect on the bigger picture. However, market turmoil has often lurked nearby – most recently during the Covid-19 crisis.

This week's retreat will be Lagarde's first face-to-face visit since she became ECB president in late 2019, and will include discussions on globalization, labor markets and digital currencies. But central banks will face more pressing questions about how they intend to preserve the integrity of the eurozone by stopping inflation.

On Friday, two days after the conclusion of their meeting, data is expected to show consumer prices in the 19-member bloc hit a new all-time high in June. The economy predicts that it will reach 8.5%.

For those concerned about another bond crisis, there is reason to hope it can be avoided: average interest rates on debt are lower than they were a decade ago, and average debt maturities are longer because the ECB holds many outstanding bonds, according to economists at Barclays Plc. 

"Rising inflation is forcing central banks to tighten policy harder and faster. These price pressures are also intensifying in the euro area, prompting the European Central Bank to develop a roadmap for the removal of incentives starting in July."

--Maeva Cousin, Senior Economist in the Eurozone. For more information, click here.

However, there are other sources of discomfort at the ECB. Officials will also face growing skepticism among the upper echelons of their profession that rising prices can be contained without seriously hurting the economy. Manufacturing output is already declining for the first time in two years.

This creates the risk that they will eventually become excessively tough, as their predecessors in 2008 and 2011 are still accused. 

Fed Chairman Jerome Powell, who will also attend the event, last week gave his clearest acknowledgment of the dangers of a downturn, saying an outcome was possible and that achieving a soft landing was "very difficult."

For the eurozone, the immediate economic risks are perhaps even higher than in the US, given some lies beyond the influence of monetary policy. Spillover effects from Russia's invasion of Ukraine have hit producers, while forecasts of a recession in Germany are growing as the Kremlin restricts energy supplies.

Commerzbank economist Jörg Kremer, who expects a U.S. recession next year and, for now, growth of less than 1% in the euro zone, says the ECB is likely to react "sensitively" if the outlook worsens.

"Hanging over all of our predictions, like a sword of Damocles, is the possibility that Putin will permanently and completely turn off the gas tap," he said Friday in a report to customers.