• Richard Walker

Inflation vs Fragmentation: A very European dilemma


  • In a previous post we examined the Federal Reserve’s monetary policy; specifically the use of QE and short end rate changes to achieve price stability. Broadly speaking the Fed seeks to keep the PCE (Personal Consumption Expenditures) rate near 2%.

  • This post looks at the monetary policy of the European Central Bank (ECB). In similar fashion to our Federal Reserve Analysis we will look at Euro rate movements and Euro yield curve shape over time. We will look at the impact that this has had on Euro inflation.

  • We discuss key difference between the mandate of the ECB and that of the Fed.

  • We compare the approaches & results of the two Central Banks over the past couple of decades to see which bloc has performed best with respect to price stability.

  • We then conclude with an opinion on which Bank will be aggressive / hawkish with respect to price stability and which will be more passive / dovish.

Price Stability at the ECB

The inflation target of the ECB can be seen here. The pertinent information is shown below in figure 1.

Figure 1 - Screenshot from the ECB website with details of price stability targets (https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html)

With some caveats the commitment of the ECB is to maintain the Harmonised Index of Consumer Prices (HICP) measured by Eurostat at or around 2%. Different index, but similar intent to the US Federal Reserve.

Comparison Between the US and the Eurozone

Figure 2 below shows the annual HICP rate (in green) vs the US PCE rate (in red).

Figure 2. USD PCE rate (shown in red) vs EUR HICP rate (shown in green) for the past 25 years

As the chart above shows both banks seem to have met their goal of maintaining their chosen inflation benchmark at or around 2% until the first half of 2022.

On this visual evidence (the red line looks closer to 2% than the green line) it seems as though the Fed has been able to more tightly target 2%.

More quantitatively If we take the mean squared error as our measure of deviation then the Fed achieves a deviation of just 0.26, compared with the ECB of 1.31.

This is consistent with what we see in the chart. Over this timeframe US inflation has been closer to 2% than inflation in Europe.

Policy response from the ECB

As with the Fed data we can chart the policy response of the ECB to achieve the inflation target. Recall there are three rates set by the ECB

  • MRO. Main Refinancing Operations. This provides the bulk of liquidity to the EUR financial system. Essentially the one week term repo rate between banks and the ECB

  • Deposit Facility. The overnight deposit rate ‘paid’ by the ECB on cash deposits. As this rate is currently negative (June 2022) the ECB receives interest.

  • Margin Lending Facility. The rate paid by banks when they seek to use overnight credit outside of the refinancing operation.

Figure 3 below shows the EUR Deposit facility & EUR HICP.

Figure 3. EUR overnight rate (deposit facility shown in red) vs HICP (in green)

The chart in figure 3 is split into the following regimes:

  1. The period up to 2008 (which covers the launch of the single currency in Jan 1999) shows inflation at or around the 2% target and the Deposit Rate varying between 2% and 5%.

  2. The aftermath of the financial crisis in 2008 saw the deposit rate drop from 5% to just above zero.

  3. There was a brief rise in rates around the time of the sovereign debt crisis in 2011. At this time HICP was edging towards 3%.

  4. Since the Sovereign Debt Crisis in 2011 the Deposit rate has been trending downwards, going negative in the middle of the decade.

  5. HICP went above 2% in July 2021 and 3% in August of that year. It has increased from 3% in each month since that time and is currently over 8%.

If we look at longer term rates using the German Govt 10 Yr Bond yield we see a picture of generally declining long term rates; from about 6% in 1997 down towards zero in 2015. (See figure 4 below)

Figure 4. German Bund Market Yield (red) vs HICP (green) for the past 25 years

The ECB started QE in 2015 and since that time 10Yr rates have hovered just above or just below zero. The very steep rise in inflation, commencing in 2021 (see sharp increase in green line on the right of figure 4 above), has seen 10Yr rates flip into positive territory. This can be seen in the red trace going just above the x-axis at the far right in figure 4..

As with the Fed rates we can look at an animated plot of the EUR term structure of rates and compare this with the HICP plot. This is shown in figure 5. If you hit the ”Play” button you can see the HICP index (in blue), term Euro rates (the red curve) for a variety of dates (shown in yellow) since 1997. While not as tightly constrained to 2% as PCE is, one can see evidence in the animated plot below of flexes, rises and falls in the EUR yield curve to achieve a 2% inflation target.

Figure 5. Animated plot of EUR rate term structure (red line), HICP rate (blue) for monhtly dates since 1997 (yellow)

The challenges of rigid monetary policy across the Eurozone.

The ECB has some additional challenges when compared to the United States. Political Union lags monetary union. EU Countries are free to set their own taxes and issue their own bonds. Some countries in the EU can be prospering while at the same time others are in recession.

Booms in asset valuations, housing and construction in certain countries have led to increased lending and overheated credit markets, whereas other countries have been more frugal with lending and credit.

Furthermore language and cultural barriers make it harder for European citizens to relocate from a country with high unemployment to one with many job vacancies.

The more integrated, homogeneous United States, (which can set Federal taxes and issue Federal Bonds) suffers less from these challenges. The ECB has to accomodate for widely diverging economic conditions in each of its member states. At a particular point in time a rate rise might be appropriate in one country, whereas a contradictory rate easing might be the best policy for a another country.

The challenge of fragmentation

With inflation surging across the Eurozone a rise in rates might be warranted to encourage saving and discourage borrowing and spending. But countries with high levels of debt with respect to the size of their economy would find this challenging. To service the debt they must either increase taxes - always politically challenging - or, roll their debt by issuing new bonds as existing bonds mature. With low interest rates the second option is nearly always the default choice...

But with the expectation of rate rises to tame inflation the spreads on some European countries sovereign bonds over German Bunds have risen sharply. Of most interest in the press has been Italian BTPs (but they are not alone, other government debt spreads have risen). Figure 6 below shows the benchmark rates for Italian BTPs and German Bunds for the last 15 years. This covers the period late in 2011 which saw the European sovereign debt crisis. Here you can see the BTP yield pushing 7% while the Bund is near 2%.

Figure 6. The market yields on German Bunds (red) and Italian BTPs (green) for the past 15 years

A holistic look at this spread data along with inflation is shown in figure 7 below. Here we see the BTP/Bund spread (in red) with EUR HICP superimposed (in green). A small rise in spreads occurred in 2007/2008. This followed a small rise in inflation around the time of the financial crisis. A larger rise in inflation was seen in 2010/2011, this was followed by a larger increase in spreads at the end of 2011.

Figure 7. The BTP/Bund Spread (red) and HICP (green) for the past 25 years

A much, much larger increase in HICP has been seen since the summer of 2021, and as before the BTP/Bund spread has started to rise (after a discernible lag).

Preventing a repeat of the 2007 and 2011 increases in spreads is, one is certain, uppermost in the minds of the shapers of European monetary policy right now. This chart, and others like it in most financial journals, provide some sobering context for Christine Lagarde’s focus on ‘fragmentation risk’ an a promise to develop ‘anti-fragmentation tools’.

What can we take from this?

It therefore seems unlikely that the ECB will act as aggressively as the Fed in raising rates. The sharp rise in EUR HICP inflation began in the middle of 2021, whereas the inflexion in PCE rates did not start until early 2022. So if one uses the change in direction of each bloc’s inflation target as the ‘starting gun’ (see figure 1) the US can be regarded as acting swifter. We have also seen a Fed policy of maintaining PCE closer to 2% than the ECB keeping HICP at or near its target (again see figure 1). Finally the concerns of fragmentation and widening spreads in European Sovereign debt mean that the ECB has limits to how much it can raise rates. It faces a unique set of pressures that other central banks (US, Bank of England, Swiss National Bank) simply do not.


  • We have looked at the ECBs monetary policy, specifically price stability / inflation targeting

  • We have compared the stability to HICP to PCE, as a means of analysing the policy actions of the ECB relative to the US Federal Reserve.

  • This has shown that the ECB has taken a more relaxed stance than in the Fed in approaching price stability; meaning that the US has maintained its chosen benchmark closer to its target rate for the past couple of decades.

  • We have argued that the ECB faces a unique set of circumstances. In particular the widening of spreads between member states’ government bonds.

  • We therefore believe, taking all of this analysis into account, that it is unlikely (highly unlikely) that the ECB will act either as quickly or as aggressively as other Central Banks, the US Federal Reserve in particular.

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