Is the ECB’s new ‘anti-fragmentation’ tool up to the job?
As the ECB's trilemma comes to a head, we review its new tool for managing the crisis in southern European debt
Most central banks are facing the dilemma of how to support growth while taming inflation.
As the latter becomes the priority, policy responses are moving in ever larger increments. Last week the European Central Bank (ECB) finally joined the rate-hiking party, increasing interest rates for the first time since 2011.
Like all policymakers around the world, the ECB has been facing surging inflation since mid-2021 – so why has it waited?
In one word: Italy.
In more words: after years of undershooting its inflation mandate, the ECB now needs to find a way to raise the risk-free rates but in a controlled, orderly way.
As the market began to price in policy tightening, the aggressive widening of Italian bonds’ spreads against those of Germany brought concerns over market fragmentation and debt sustainability back into focus. Italy is a particular concern for investors, given its enormous debt burden, and as we can see below, the country has undergone a rollercoaster ride over the last decade:
The unique institutional set up of the euro area – 19 countries under one central bank – means the ECB now faces a trilemma.
As if underpinning growth while limiting inflation wasn’t tough enough, it must balance both these priorities with sustaining huge imbalances in public debt between different members of the euro area.
How is the ECB meeting this challenge?
Welcome to ECB’s new policy tool and future pub quiz question – the Transmission Protection Instrument (TPI).
Although the ECB maintains that reinvestments under its pandemic-era asset purchase programme remain the first line of defence, the TPI is potentially more powerful .
How does it compare to the already-deployed Securities Markets Programme (SMP) and its successor Outright Monetary Transactions (OMT)?
Potentially unlimited and right up there with the SMP and OMT. It is likely the ECB has enough space to stay within the issuer limits of 50% for the highest-debt countries – i.e. Italy.
These are just as important as size. The SMP had no communicated eligibility criteria, so all countries could potentially benefit, while the OMT required a country to already be in a bailout programme that demanded significant monitoring. This high bar meant the OMT became a last resort.
The TPI also requires adherence to several fiscal frameworks, but with the European Commission suspending its fiscal rules for this year and 2023, the reality is that the conditionality of the tool appears to be quite a bit looser.
This is possibly the trickiest aspect to define and score.
Activation of TPI will no doubt be subject to much debate, particularly on what counts as “unwarranted, disorderly market dynamics”, that require a response.
Equally, the ECB says that purchases could be terminated “based on an assessment that persistent tensions are due to country fundamentals.” How the ECB will determine how much spread widening is thanks to fundamentals will be difficult.
The manner in which the ECB will conduct its operations for TPI is also a mystery.
Some details in areas like ‘sterilisation’ of asset purchases have been deliberately held back. Overall, it’s hard to give TPI a high score on this front. That said, the ECB has communicated more on fragmentation risks and stressed some established frameworks as a point of reference, so TPI is neither a ‘black box’ like SMP, nor is it as clear cut as the OMT’s very strict monitoring and framework protocols.
Time and again the ECB has had to fight off challenges to its use of policy tools, and so far it has been able to navigate them relatively successfully.
SMP was considered by some to be a contravention of the EU treaty clause prohibiting monetary financing of governments and the ‘no-bailout’ clause of the Stability and Growth Pact.
Meanwhile, OMT was dragged through the German Constitutional Court and the European Court of Justice. By referencing the proportionate nature of the tool and staying within the issuer limits that apply to other tools, the risk of legal challenge to TPI is probably mitigated and the ECB can most likely commence without any immediate risks.
Here’s a handy graphic summing up where TPI sits in relation to other tools:
Is it enough, and can the ECB hike more?
On the whole, we think the TPI scores well against OMT. But do markets agree?
The reaction so far has been fairly muted, with BTP spreads largely unchanged in the week since TPI was unveiled. It’s likely that the collapse of the Italian government on the very same day has served to counteract any relief markets may have felt from the ECB delivering a large and flexible tool, and the market may still end up testing the ECB’s resolve as Italy heads to early elections in September.
Of course, the market’s other focus is the third part of the trilemma: growth.
We believe the euro area is currently slipping into recession as energy prices and supply constraints take their toll. In the short term, we believe the ECB will still focus on lowering inflation and inflation expectations by raising interest rates further in the coming few months.
TPI in theory should allow the central bank to hike faster, but trend growth across the euro area is only around 1%, so the ECB faces more of a challenge than other global central banks in controlling rampant inflation without tipping the economy into recession.
We think the ECB will still be able to raise rates further – but ultimately less than its peers.