FRANKFURT ― The markets are jittery and inflation still needs taming. Coming together, those two things put the European Central Bank in a real bind.

Fight one fire and it could cause the other to flare. The ECB can keep raising interest rates to try to get inflation under control, but that risks fueling financial market tensions. Conversely, it can give banks some breathing space by slowing its rate-hiking, but that carries the danger of prolonging the region’s economic malaise.

Frankfurt’s official line is that it can do both with no serious consequences. Many economists in the eurozone don’t buy that.

In private, it’s a dilemma that splits the ECB’s decision-makers, and even in public differences of opinion are bubbling to the surface. Here’s what’s at stake:

Why is the ECB raising rates?

The idea is that increasing interest rates subdues inflation because it makes consumers and businesses less likely to borrow ― so that results in reduced spending.

As inflation has started to pick up since last summer, the ECB has raised interest rates at a record pace. They’ve gone from -0.5 to 3 percent as the annual rate of price rises has surged to a eurozone record 10.6 percent in October.

The Bank tries to keep inflation at 2 percent so it’s currently way off target.

How this contributed to the crisis

The unpleasant side effect is that with rising borrowing costs (because of higher interest rates), the value of bonds that banks hold usually fall. This gives investors a bad case of the jitters. After the collapse in March of lenders like Silicon Valley Bank and Credit Suisse ― though their problems seemed unconnected ― it was this that prompted concerns they might not be the only institutions with troubles, and fueled contagion fears around the globe.

But Lagarde plowed on regardless

The ECB remained unfazed in the face of emerging banking troubles: It delivered a previously signaled 0.5 percentage-point rate increase in March, less than a week after SVB failed and at a time when Swiss banking giant Credit Suisse was teetering.

Following that decision, ECB President Christine Lagarde stressed that she sees no trade-off between ensuring price stability and financial stability.  

In fact, she said the Bank could continue to lift rates while addressing banking troubles with other tools.

The case against

Many economists disagree with Lagarde that the battle for price stability can be pursued without risking financial stability.

Claiming so “should be a career-ending statement,” said Stefan Gerlach, chief economist at EFG Bank in Zurich and a former deputy governor of the Central Bank of Ireland. “This is the idea of the ‘separation principle’ of 2008 revisited. That wasn’t a good idea then, and isn’t now either,” he added.

What’s the separation principle?

In 2008, at the start of the financial crisis, as well as in 2011, when the sovereign debt crisis hit, the ECB adhered to the idea that interest rates could be used to ensure price stability at the same time as other measures, such as generous liquidity injections, could ease market tension.

But this just added to the problems and had to be unwound quickly.

This time around, the Portuguese member on the ECB Governing Council, whose country suffered particularly under the consequences of the sovereign debt crisis, is less blasé than Lagarde.

“Our history tells us that we had to backtrack a couple of times already during processes of tightening given threats to financial stability. We cannot risk that this time,” Mario Centeno told POLITICO in an interview. 

The case for Lagarde

After the initial fears that troubles could spread across the eurozone, investor nerves have calmed and bank shares started to recover. At the same time, new data showed that underlying inflation pressures kept rising, suggesting that Lagarde and her colleagues were right to stick to their guns ― at least for now.

If that’s the case, March’s interest rate rise ― what Commerzbank economist Jörg Krämer described as “necessary” investment in the central bank’s credibility ― will have paid off.

Market turmoil actually helps

The nervous markets could help the ECB to reach its inflation target without having to raise interest rates as aggressively as previously thought.

Banks tend to slap an additional risk premium on their lending rates which raises the cost of borrowing money for consumers and business. So banks end up doing part of the tightening job for the central bank.

ECB Vice President Luis de Guindos suggested as much in an interview released last month, though he cautioned that it was too early to assess how much impact exactly it may have.

What’s the endgame?

The challenge for the ECB is to strike the right balance. If it doesn’t it risks either the repeat of 2008-style financial troubles or a return to the stagflationary period (low growth on top of high inflation) that roiled the Continent in the 1970s.

If it raises rates too aggressively, bank failures followed by a recession risks forcing the ECB into an interest rate U-turn for the third time, creating massive credibility risks. Conversely, if they don’t hike enough, the central bank may lose a grip on inflation, which is its main mandate.

The only way Lagarde can win is to deliver both price stability and financial stability. In that sense, there is no trade-off ― one without the other just won’t be enough.