The ECB’s policy conundrum

The European Central Bank’s Governing Council faces a conundrum as it speeds up the withdrawal of stimulus to tackle accelerating inflation. The rapid tightening of monetary policy and expectations of its future path threatened to incite financial market fragmentation through widening spreads on sovereign bonds across the eurozone over the spring of 2022. The Governing Council of the ECB must walk a fine line between unwinding its unconventional monetary policy tools, while preventing the fragmentation of European financial markets and potential disruption of the monetary transmission mechanism. This challenge is complicated by the fact that much of the potential for disruption lies in the minds of market participants. In order to maintain the ability to shape market expectations, the Governing Council requires credibility, yet that credibility suffered a hit as the ECB had to walk back much of its forward guidance from late 2021. Fortunately, the Governing Council appears to have a plan, and that plan appears to be working. The next two meetings will be crucial in deciding just how much it can deliver