Although you might not have realised it from Christine Lagarde’s understated delivery, the European Central Bank last week became much more pugnacious towards both financial markets and the euro zone’s fiscal policymakers.
For quite some time the ECB, which Lagarde heads, has been visibly uncomfortable about being “the only game in town”. It was long left to the central bank to push monetary policy close to its limits to sustain aggregate demand, and to find legally watertight mechanisms to stop speculative attacks on the integrity of the euro and maintain solvency among its members.
In deciding last week to raise interest rates by a higher-than-signalled half a percentage point and to introduce a new “Transmission Protection Instrument” bond-buying programme, the euro’s central bank has turned the tables.
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The rate decision was punchy and clearly intended to flex some tightening monetary muscle. The message seemed to be that markets should be aware that the ECB would not hesitate to curb inflation and to prepare themselves. But the TPI (to use the latest acronym) is by far the more consequential policy and political economy move.
The ECB has taken upon itself to prevent the divergence of sovereign borrowing costs, if it judges that divergence to be “disorderly” and “unwarranted” and to interfere with its monetary policy stance. In plain language that means avoiding panicky sovereign debt market sell-offs when ECB monetary tightening prompts investors to ask what rising rates would do to a euro-zone government’s debt dynamics.
Those investors have been put on notice. Lagarde’s press conference suggested that the spread widening that the ECB is seeking to stop is the self-fulfilling kind, where bond prices deteriorate for no other reason than market participants expect them to. One might put it this way: the ECB will not tolerate market dynamics that, rather than reflecting economic realities, create their own.
And it will intervene to prevent this. The euro has always been particularly vulnerable to the tendency for financial markets to jump from a “good equilibrium” to a “bad equilibrium” when psychology changes. The TPI is the ECB’s commitment to rooting out the “bad equilibria”.
Owning decisions
The central bank has put the rest of the EU’s governing system on notice as well. The eligibility criteria draw heavily on the economic governance mechanisms in the European Commission and the Eurogroup of finance ministers. To shore up a country’s bonds under TPI, the ECB will look at whether its government is abiding by commission and Eurogroup policy recommendations. It is telling elected leaders not to outsource political judgments, daring them to own the decisions that determine whether a country should be protected against speculative attacks.
Without saying it in as many words, the ECB is belatedly making use of its neglected secondary mandate. This is often forgotten or outright denied, but subject to stabilising prices, the ECB is legally obliged to support the bloc’s general economic policies. It is doing so while simultaneously reminding everyone who has the authority to determine those policies. The onus is on politicians to get their policies in order — but if they do, the ECB will support them and prevent market panic.
TPI will work best as credible deterrence: an instrument you could use but most likely will not have to
Mario Draghi’s resignation as Italian prime minister on the same day the ECB announced its new instrument puts this new dispensation of decision-making in stark relief. The TPI criteria make Italian bonds immediately eligible for TPI if the ECB sees fit. But this could be short-lived, for those criteria include compliance with a country’s EU-funded recovery plan. Draghi has said Italy must fulfil 55 policy actions by the end of the year to remain compliant.
That will weigh on whoever takes over in Rome in the next few months, and on those in Brussels who have to assess Italian compliance. Precisely by promising to do its bit, the ECB has placed more responsibility on politicians’ shoulders.
The central bank’s own work is not done, however. TPI will work best as credible deterrence: an instrument you could use but most likely will not have to. But Lagarde, bizarrely, wants to keep markets somewhat in the dark. “There are certain components [of TPI] that are best kept unpublished, undisclosed, uncommented upon,” she said. She also volunteered that “we would rather not use it”, although “if we have to use it, we will not hesitate”. The second part of that statement would have been enough. As it is, the ECB is likely to be tested by financial markets before too long. — Copyright The Financial Times Limited 2022
