The ECB’s Dilemmas
The future of the eurozone hangs by a thread
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The ECB’s Dilemma: Normalising without Fragmenting the Eurozone
Christine Largarde called it "a rather historical moment". On 21st July the Governing Council of the European Central Bank (ECB) decided to raise the ECB's key interest rates by 50 basis points (0.5%) and announced the creation of a Transmission Protection Instrument (TPI).
PERFECT STORM • The ECB is hampered in the execution of its tasks by the incompleteness of the eurozone. Monetary union has not been complemented by economic and financial union. The economic policies of euro countries are loosely coordinated, and a significant central fiscal capacity does not yet exist. When the ECB raises interest rates, it puts pressure on debtor countries; the lack of a fiscal backstop means that it could send the latter into a vicious cycle of increasing borrowing costs and decreasing market confidence in the sustainability of their debt.
At present, the ECB has to return its monetary policy to post-pandemic normality, without causing the fragmentation of financing conditions within the eurozone — that is to say, without triggering a financial crisis. It has to execute this balancing act in the midst of a storm, moreover: the euro has fallen to a 20-year low against the dollar and the resignation of Mario Draghi is sending Italian bond yields to new heights.
Krishna Guha of Evercore summarises the situation in the columns of the FT:
"The combination of a brewing giant stagflationary shock from weaponised Russian natural gas and a political crisis in Italy is about as close to a perfect storm as can be imagined for the ECB".
NORMALISATION • The rate increase — 50 basis points — is higher than that which had been announced (25 bps) in Amsterdam in June. It sends a signal to markets that the ECB is genuinely ready to fight inflation in the eurozone, which reached 8.6% in June, year-over-year.
This is the first rate hike since 2011, ending an exceptional period of negative rates. In the United States, the Fed has already raised interest rates several times, which are now firmly in positive territory. This has increased the attractiveness of the dollar, which functions, in any case, as a safe currency in times of macroeconomic uncertainty.
Inflation in the euro area, which has mainly been driven by rising energy and food prices, is exacerbated by the decline of the euro against the dollar. The euro briefly fell below parity with the dollar before the ECB raised its interest rates. If Russia decides to suspend gas deliveries through Nord Stream I, this could further add to the inflationary pressures. Overall, the ECB’s unexpectedly large increase of its interest rates reflects its confidence in its ability to contain an increase in spreads (gaps between the bond yields of debtor countries and that of Germany) through its new instrument, the TPI.
The large rise in interest rates was not unanimously welcomed by the Governing Council of the ECB. First, the probability of a recession remains high. Germany’s finances are particularly vulnerable to rising energy prices, and if it plunges into a recession, it will drag many eurozone countries with it. Second, rising interest rates have different consequences for the different euro countries. Although Estonia, where inflation has reached more than 20%, will appreciate the hike in interest rates, they will be less welcome in Italy, where it will put additional pressure on its sovereign bonds. After the announcement of the rate hike, Italian 10-year bonds were at 3.7%, a gap of more than 2.3% with Germany.
TPI 101 • In March 2020, in the context of the onset of the Covid-19 pandemic, Christine Lagarde said that the ECB had no mission to close spreads, which caused a surge in Italian borrowing rates. The launch of the TPI effectively confirms the fact that closing spreads is at least part of the ECB’s mission. The Governing Council reached unanimity for the vote of the TPI.
The Transmission Protection Instrument will enable the ECB to intervene to counter sudden increases in interest rates in some euro area countries through purchases of public assets on the secondary market.
"The TPI will be an addition to our toolkit and can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area. By safeguarding the transmission mechanism, the TPI will allow the Governing Council to more effectively deliver on its price stability mandate" — Press release
The TPI adds to the ECB’s already impressive arsenal of monetary crisis tools, of which the OMT programme and the PEPP are the most formidable. In 2020, the ECB launched the Pandemic Emergency Purchase Programme (PEPP): a temporary asset purchase programme to combat the economic effects of the Covid-19 pandemic. Some had expressed their support for the use of the flexibilities provided for under the PEPP rather than developing a new instrument in the face of the current situation.
WHATEVER IT TAKES • The ECB has not set a limit on the asset purchases which it can undertake, although it has stipulated that they must be proportionate to the objective pursued.
"The ECB is capable of going big," said the ECB President, thereby following in the footsteps of Mario Draghi, whose pledge to do "whatever it takes" to save the euro on 26 July 2012 was instrumental in calming financial markets. Draghi’s words were quickly followed by the ECB’s introduction of the Outright Monetary Transactions (OMT) programme, which allowed unlimited asset purchases by the ECB. Yet, in the end, the OMT did not even have to be activated. Draghi’s pledge proved sufficient to restore market confidence.
In a sense, though, Draghi’s famous pledge is slightly misleading: the ECB always has to act "within its mandate". Indeed, Christine Lagarde has made it clear that, although the ECB ’is capable of going big", its interventions will be strictly regulated. This will undoubtedly do nothing to prevent German academics from challenging, as usual, the legal merits of this new monetary instrument before the German and European courts, as in the case of the OMT and PSPP plans.
The ECB emphasises that the TPI aims to ensure the smooth transmission of monetary policy, which is made more difficult when interest rates diverge within the euro area. For the ECB to intervene, the country concerned will have to experience ‘a deterioration in financing conditions not warranted by country-specific fundamentals’ — in other words, be subject to speculative attacks.
Asset purchases will also be conditional on compliance with European fiscal and economic rules, in line with the conditions for obtaining the funds of the Next Generation EU (NGEU) recovery plan. Italy will therefore not be able to bin the reforms promised by Mario Draghi to the European Commission within the framework of NGEU.
POLITICAL TOOL? • ‘’Economic fundamentals" form a somewhat subjective category; and nor is it obvious when market conditions are "disorderly and unwarranted". At her press conference, Christine Lagarde indicated that "multiple indicators" would be taken into account when assessing market dynamics, without specifying which ones.
Shahin Vallée explains in Geoeconomics that it is difficult to define when the TPI would be triggered:
"This is a more difficult question because the ECB has been careful to avoid drawing a line in the sand that would be the object of immediate speculation. Instead, it is referring only to disorderly and unwarranted market dynamics (ie. volatility, second moment rather than spread levels) stressing that it considered current conditions as NOT warranting an intervention. The problem here is that despite the formulation, this will invite markets to test what disorderly and unwarranted means?"
Philippa Sigl-Glöckner of Dezernat Zukunft adds the following in the FT:
"The current institutional set-up thus muddies the waters: to pursue its mandate, the ECB must address spreads. But addressing spreads has fiscal consequences. In particular, in addressing spreads, the ECB effectively decides which member states benefit from the privilege of sovereign borrowing, under what conditions and at which price. That is a deeply political issue, on which a technocratic, non-elected body is ill-suited to pronounce".
This leaves doubt about the implementation of the TPI. What if Italian rates rise due to political instability? In that case, the market is merely reflecting uncertainty about the country's economic policy, and it could be argued that the ECB should let the market integrate this risk into its Italian bond premium.
This is what Christine Lagarde suggested at a press conference:
"Political matters are for the democratic process of each and every member state, and that is certainly the case for the country that you are referring to. Differences in local financing [conditions] can legitimately arise" — Christine Lagarde
What we’ve been reading this week
A report by the European Stability Initiative laments the ‘turtle race’ that the path to EU membership for Balkan states has become. It calls for Europe to signal its seriousness by giving access to the Single Market to any country that meets criteria related to democracy and the rule of law.
Shahin Vallée analyses in Geoeconomics the ECB's launch of the TPI, which he argues makes the Frankfurt institution the ultimate judge of the sustainability of eurozone states' debt, and sheds light on the ECB's internal geopolitics.
In the FT's opinion column, Philippa Sigl-Glöckner, founder of the think-tank Dezernat Zukunft, warns of the fiscal consequences for member states of launching the IPT.
This week’s newsletter is brought to you by Rogier Prins, Maxence de La Rochère and Thomas Harbor. See you next Tuesday!