About the author: Silvia Merler is the head of ESG and policy research at Algebris Investments and an adjunct lecturer in economics of global markets at the Johns Hopkins School of Advanced International Studies.
Eight years after introducing its negative interest rate policy, and now faced with record-breaking inflation across the euro zone, the European Central Bank has announced that it will begin to increase interest rates starting in July. -year sovereign bonds to 4%, prompting the ECB to call an emergency meeting, reinstating its commitment to deploy flexibility within existing instruments, and announcing the development of a new tool to stave off “financial fragmentation.”
Reversing the monetary policy stance after more than a decade of easing was always going to be a delicate endeavor. Still, the ECB faces an exceptionally complex task because its single policy rate transmits across a heterogeneous monetary union where capital markets are not fully integrated, and financing conditions are linked to 19 sovereign yield curves underpinned by diverse macroeconomic fundamentals.
Due to this unique setting, the ECB has one major problem that the US Federal Reserve does not have, when raising rates—namely, financial fragmentation. At its core, financial fragmentation manifests as a significant widening of the differentials in sovereign bond yields across euro zone members. It matters because it leads to the common monetary stance transmitting asymmetrically across countries and driving a divergence in financing conditions that in the past has been so extreme as to call into question the survival of the euro.
Following the experience of the euro crisis, the ECB’s role has thus been greatly extended beyond its price stability mandate, adding de facto In a hiking phase, however, the goals of maintaining price stability and ensuring financial stability in the Eurozone are in contradiction.
So far, the ECB’s announcement has brought calm to the euro zone peripheral’s sovereign bond markets. Whether it lasts will depend on the details of the new tool that is under study in Frankfurt. Several important questions remain open.
First, what will be the target? A recent speech by ECB Board Member Isabel Schnabel suggested the focus will be on “nonfundamental fragmentation risk.” In determining the level of yield and spread consistent with fundamentals, the ECB will need to square a trade- off between being transparent enough to avoid legal challenges on monetary financing and maintaining sufficient ambiguity to deter speculative action. The choice to call an emergency meeting at a level of spread that many in the market believed to be below the threshold for intervention has drawn a clear line in the sand, which ECB President Christine Lagarde later attempted to blur by adding that the trigger could be both the level and the speed in spread dynamics. Without convincing details, that line is likely to be tested again.
Second, what will be the structure? Existing tools won’t work. The ECB introduced an assets purchase facility in 2020, called the Pandemic Emergency Purchase Program. It will use reinvestments under that program flexibly to contain spreads. That will help, especially if But the ECB has a self-imposed requirement for PEPP holdings to reconverge over the medium term toward an allocation in line with the capital key, a weighting of national assets according to GDP and population. is likely), volumes would be too low for PEPP to prevent spreads on peripheral countries from reaching crisis levels. To be credible, the new anti-fragmentation instrument would thus need to combine the flexibility of PEPP with the open-endedness of another flagship ECB tool, namely the Outright Monetary Transactions.
As such, it will be exposed to both technical and legal challenges, and the ECB will need to balance achieving effectiveness and limiting the risk that its intervention is perceived as fiscal dominance, a situation in which the central bank is forced to react to policies set by national governments. This is likely to be achieved by introducing some form of conditionality. But what will that be?
Conditionality for this tool should be as light and automatic as possible. Most commentators see eligibility for intervention potentially tied to ongoing progress under Next Generation EU or the broader European Semester—two processes aimed at coordinating the EU’s long-term economic trajectory. Both are, A better option would be for the European Commission and ECB to run a forward-looking, however, complex and lengthy, and tying ECB intervention to them would increase the risk of a monetary tool being politically hijacked. debt sustainability assessment confirming eligibility of all Eurozone members for potential intervention. This is the route that was followed for the European Stability Mechanism’s Pandemic Crisis Support in 2020.
To limit challenges on monetary financing grounds, the ECB will also want to frame the tool as strictly targeting monetary transmission over the horizon of rate increases. PEPP’s role was to address an asymmetric tightening of financing conditions over the medium term due to the pandemic. OMT’s is to prevent extreme liquidity crises in the short term due to capital flight. The new tool may focus on maturities between these two poles. Lastly, purchases will likely need to be offset by reducing other sections of the balance-sheet, or “sterilized , ”To allow the ECB to compress spreads while maintaining an overall tightening in its monetary policy stance. This is essential for the ECB to avoid sending conflicting messages on its commitment to rein in inflation.
The press reports that the ECB might sell “other securities” to offset the balance sheet effect of its action under the new anti-fragmentation tool, similar in principle to the Fed’s Operation Twist. But it remains unclear whether sterilization would see the ECB buy and The latter option is probably easier, as it would resemble the mechanics already applied to the 2010 Securities Markets Programme. The alternative would see the ECB actively putting upward pressure. on core yields and overtightening in core countries while doing the opposite on the parity, which is untested and would likely expose it to new legal challenges.
Markets are likely to give ECB the benefit of the doubt over the next few months, also in light of its historical success in defending the peripheral, but they will soon want to read the fine print on the new tool. Curbing inflation while preventing a resumption of fragmentation, all by remaining within the constraints of the complex Eurozone legal framework, will require the ECB to be creative and ECB policy to become even more need-based than it has been during the pandemic.
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