A month has passed since the disappearance of Credit Suisse, and investors are still convinced that the European Central Bank will keep increasing interest rates to fight inflation.

This is contrary to the prevailing sentiment just four weeks ago. It was expected that the banking crisis would slow credit growth, slow down the economy, and relieve policymakers to tighten policy. Since then, Goldman Sachs Group has reinstated its forecast of a pic rate of 3.75% after lowering it to 3.5% after the banking tumult. The swift re-evaluation shows that the focus has quickly shifted back to the risk of persistent inflation.

The odds of rates rising to 3.75% have more than doubled and are now even higher than in February when surprisingly solid economic data sparked bets on policy tightening. As gauged by swaps tied to policy meetings, money market bets are closely aligning with a Bloomberg survey of economists this week which showed the ECB is expected to raise its interest rates three-quarters of a percentage point in May, June, and July. Though it has significantly slowed this year, inflation in the eurozone is still more than three times the ECB’s 2% target.

However, an eternal country could change the ECB trajectory: Italy. The European Central Bank’s tightening cycle has put Italy’s debt-to-GDP ratio on an unsustainable trajectory. A more significant surplus in Rome could offset these higher borrowing costs, but this would be politically difficult to achieve. This leaves the country more vulnerable to a sudden loss of investor confidence, as some banks have experienced in recent weeks.

The recent uptick in borrowing costs induced by the ECB’s monetary tightening will take the debt-to-GDP ratio to 168% of GDP by 2040, compared to 144% in 2022. Despite the Italian Finance Ministry’s forecasts, achieving a primary budget surplus (tax revenues minus public expenditure, excluding debt servicing costs) of more than 1% of GDP will be difficult.

The Italian forecasts of 2.0% in 2026 and the IMF’s of 3.2% of GDP by 2028 both seem overly optimistic. History suggests such estimates are not politically viable. The primary budget balance was, on average, 1.3% over the ten years preceding the pandemic and only reached 2.0% in one of those years. That was in 2012 when Mario Monti was Prime Minister, and he was swiftly removed from office by voters weary of austerity. Even reaching a 1.2% surplus will require a heavy dose of austerity, which looks difficult in the current Italian political context.

Italy’s sovereign borrowing costs have risen sharply over the past twelve months. The 10-year yield has increased to 4.26% from 2.48%. The outlook for monetary policy largely drove this rise. The ECB’s tightening cycle is pushing up Italy’s borrowing costs, and the cycle is not over yet.

Unfortunately, Italy is not Greece. The country falls into the ‘too big to fail’ and the ‘too big to be saved’ categories. The rise in sovereign yields is sending Italy’s debt-to-GDP ratio on a trajectory that could lead the eurozone toward a new crisis. Investors do not seem too worried yet, but a rise in the funding costs of some Italian banks could become an early warning sign of a new crisis.