It is March 2020 and Italy is in serious trouble. Italian long-term interest rates are rising rapidly, and the spreads with other eurozone countries are widening.
Christine Lagarde, then still a brand-new president of the European Central Bank (ECB), gets a question about this at a press conference. “We are not here to close spreads,” she said. Italy is furious, the country’s rates shoot up further and stock prices tumble.
Fast forward to 2025. Italy has since become the epitome of political stability in the currency union. France, meanwhile, is politically adrift and economic problems are piling up. The result: rising long-term interest rates. And Lagarde? She says she is closely monitoring developments in that area. A very different tone than back then, when Italy was in the hot seat. Lagarde, by the way, was born in France.
The ECB recently met again on interest rates and left its rates unchanged. The bank’s economists expect inflation to remain below 2 percent in the coming years and growth to come in at just over 1 percent. There are worse scenarios, I would say.
No, the real challenge for the ECB in the coming years is likely to come from another corner, namely from France. The government has fallen once again and political stability is hard to find. Instability about which government is in charge will continue into 2026, and in that year uncertainty will be added over who will be France’s president from 2027 onward. In the spring of that year, the French will elect the successor to Emmanuel Macron, who is no longer eligible.
What this means is that hardly anything is being done to curb the country’s huge budget deficit (over 5 percent of gross domestic product) and its too-high and still expanding national debt. It is therefore only a matter of time before France’s credit rating comes under further pressure, which in turn could fuel the recent sharp rise in French long-term interest rates.
Should France head toward a debt crisis, the ECB will not watch passively from the sidelines. France is the second-largest economy of the currency union, and a debt crisis there would be of an entirely different magnitude than the debt crisis in Greece back then.
The ECB created a special instrument a few years ago for precisely such circumstances, called the Transmission Protection Instrument. With this tool, the bank intends to purchase government bonds on a large scale to temper rising rates in the capital markets.
In that context, I found a recent blog on the ECB’s website quite interesting to read. The piece appeared under the title Economic uncertainty weakens monetary policy transmission. Transmission sounds like an innocent word, but whenever I see it at the ECB, some alarm bells go off for me. That has to do with the mentioned instrument.
In the article, the authors say that changes in interest rates make it cheaper or more expensive to borrow money. If the future is uncertain, the effect that a central bank wants to see when, for example, it lowers rates, is smaller than under normal circumstances. Households and companies sit on their hands, and because of the uncertainty they ignore the lower rates to borrow, spend, and invest. In short, the more uncertainty, the duller the ECB’s instruments, such as interest rates.
Put differently: to achieve the same effect, central banks have to act more forcefully, in this case lowering rates more than they normally would. Could the bank be preparing minds with this kind of publication for what it may eventually have to do, for example if France indeed ends up in a debt crisis? It is quite possible.
Edin Mujagić is an economist, manager of the Hoofbosch Investment Fund, and author of the book Turning Point 1971. He writes an ECB Watch every month for Investment Officer on the monetary policy of the European Central Bank.