(Bloomberg Opinion) -- The European Central Bank has sparked a bond-market tantrum by suggesting inflation may be running so hot that it needs to raise borrowing costs this year. Policy makers should be mindful of what happened a decade ago, when two interest-rate increases in the space of three months had to be quickly reversed.
At the end of 2010, euro-zone inflation started to poke above the central bank's 2% target, and stayed there just as wounded economies were struggling to recover from the global financial crisis. In April 2011, with consumer prices rising at an annual pace of 2.6%, the ECB raised its key policy rate by a quarter-point to 1.25%. “We always do what is necessary to deliver price stability,” then-ECB President Jean-Claude Trichet said.
Three months later, an inflation rate of 2.7% prompted a further increase to 1.5%. “It is essential recent price developments do not give rise to broad-based inflation pressures over the medium term,” Trichet said.
Problem was, the euro zone was about to be engulfed by another financial spasm — the debt-market crisis. Even at the time of that initial rate increase, Greece, Ireland and Portugal had already sought bailout assistance from the European Union as investors started to shun the bonds of single-currency members with high budget deficits. Policy makers, though, reckoned the three countries were too small to pose a systemic risk to the region.
And then the bond vigilantes turned on Italy, and then Spain. Their borrowing costs soared, with two-year yields for both nations more than doubling into the final quarter of 2011. The entire euro project was fraying.
The ECB capitulated. At its November meeting, the first under new President Mario Draghi, it unexpectedly cut its interest rate to 1.25%, following with a further reduction back down to 1% in December. It marked a swift round-trip in borrowing costs.
Fast forward to the current situation. Last week, ECB chief Christine Lagarde was widely expected to repeat her December message that rates wouldn't rise this year. Instead, the surprise jump in January inflation to a record 5.1% has clearly worried the guardians of monetary stability sufficiently to make them reconsider. The futures market is now pricing in a monetary policy rate closer to zero by the end of the year than the -0.5% level that's prevailed for more than two years. But companies and consumers across the bloc will end up paying more to borrow well before the central bank actually tightens policy.
Bond yields have shot up. Italy's two-year borrowing cost has surged to about 0.4%, far above December's average of about -0.2%. But what should worry policymakers in both Frankfurt and Milan is the climb in Italy's 10-year yield relative to that of Germany, Europe's benchmark borrower, to more than 1.5 percentage points, a level not seen for 18 months.
“While yields have moved up, spreads have not widened in any significant manner,” Lagarde said at last week's press conference. That's no longer the case, as the chart above shows. The prospect of the ECB withdrawing its support for the bond market and then raising interest rates has spooked investors who've come to rely on central banks sustaining financial markets with oodles of liquidity.
The speed and the strength of inflationary pressures have left central bankers facing questions about whether they're behind the curve. But Rupert Harrison, BlackRock Inc.'s portfolio manager for multi-asset strategies, argued in a tweet last week that they risk overreacting:
In the euro zone in particular, there's a case to be made that the current bout of price increases will ease in the second half of the year. Warmer weather will calm the upward pressure on energy prices, a big component of the recent increase in consumer prices. Moreover, the region's workers aren't clamoring for higher wages from employers, unlike in the U.S. or the U.K. As the chart below shows, the last period of above-target inflation in the euro zone proved short lived.
A decade ago, the ECB was on its own in raising interest rates, with neither the Federal Reserve nor the Bank of England seeing any need to shift their emergency post-financial crisis borrowing costs. This time, with the U.S. and U.K. central banks taking the lead, euro zone policy makers risk being bounced into acting before the economy is able to withstand tighter monetary conditions. FOMO can affect central bankers in the same way it seduces day traders into backing meme stocks.
More from Bloomberg Opinion:
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The ECB Is a Lonesome Dove No More: Marcus Ashworth
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Fed Knows What It Needs to Do. Now Comes the Hard Part: Bill Dudley
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Two Fund Behemoths Say Inflation Is Here to Stay: Mark Gilbert
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."
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