Euro area: Fiscal and monetary policy – something has to give

Fiscal deficits in some euro area countries, particular Italy and France, remain high and debt levels have increased significantly since the pandemic . While there is no sign of any rising market pressure, some fiscal adjustment is needed, not least to reduce the risks to long-term debt sustainability. What the fiscal adjustment path will look like is uncertain at this point. One reason for this uncertainty are the reformed European fiscal rules. The se new rules demand that high deficit countries will bring their deficits below 3% over a four-year period (with a potential further extension) . Thus, it seems likely that the fiscal adjustment will be only very gradual. More details will only emerge after the EU Commission has decided in June for which countries to start a n excessive deficit procedure (EDP). All this has also implications for the ECB and the future path of m onetary policy. A more ambitious fiscal adjustment in the high-deficit countries would allow, all else equal, a more forceful policy easing than a gradual adjustment . But t he fiscal path will also determine the ECB’s ability to intervene in sovereign markets under its Transmission Protection Inst rument (TPI) should “unwarranted, disorderly market dynamics” lead to a sharp spread widening. After all, “compliance with the EU fiscal framework” is an eligibility criterion for the TPI .