The European Central Bank (ECB) has a dilemma. With the Eurozone facing unprecedented inflation (8.6 percent in June), many on the Governing Council want to see a rapid and substantial rise in interest rates. But raising rates too much, or too quickly, risks destabilizing the euro by threatening the fiscal sustainability of the Eurozone’s most indebted countries. Italy, the European Union’s third-largest economy, is the chief concern.

Recent political turbulence there — culminating in the resignation of prime minister Mario Draghi — spooked investors in Italian sovereign debt. As a result, the spread — or the difference in yield — between Italian and German bonds rose to its highest level since the height of the COVID-19 crisis in 2020. Although Italian bonds have since recovered, further monetary tightening could easily cause spreads to widen again, leading to a speculative flight from the country’s debt.

In an attempt to square this circle, the ECB made a dual announcement late last month: it would hike rates by 0.5 percent, but it would also introduce a new instrument designed to contain the fallout of rate hikes in the bond markets — the so-called Transmission Protection Instrument (TPI). The TPI permits the central bank to buy up sovereign debt in unlimited quantities whenever it determines that a country is “experiencing a deterioration in financing conditions not warranted by country-specific fundamentals.”