What will the European Central Bank Do?

Investors are quickly losing faith in one of the world’s largest sovereign-bond markets, driving the yield on the benchmark 10 year Italian bond up to 7.45%.  Rates are at their highest level since the inception of the euro.  Italian Prime Minister Silvio Berlusconi pledged Tuesday to step down after Parliament approves austerity measures intended to reassure investors and ensure that Italy remains able to borrow.

The new President of the European Central Bank (ECB), Mario Draghi may have to aggressively print Euros to buy Italian government debt.  The primary objective of the ECB is to maintain price stability within the Eurozone, which is the same as keeping inflation low. The ECB Governing Council defines price stability as inflation of around 2%.  Mr. Draghi cut short-term interest rates in his first meeting.  Certainly he doesn't want to aggressively expand the Euro, but given the recent interest rate spike, it appears he will have no choice but to buy Italian bonds to support their prices (and bring their interest rate down).  It is somewhat notable that Mr. Draghi is Italian, so he is likely feeling extra pressure.