Although you may not have heard from Christine Lagarde’s understated speech, the European Central Bank became much more dovish last week towards both financial markets and eurozone fiscal officials.
The ECB, which Lagarde heads, has been visibly uncomfortable with being “the only game in town” for some time. It has long been left to the central bank to push monetary policy to the limit to support aggregate demand. And to find legally watertight mechanisms to stop speculative attacks on the integrity of the euro and to preserve the solvency of its members.
The euro central bank turned the tables with last week’s decision to raise interest rates by half a percentage point more than announced and to introduce a new “Transmission Protection Instrument” asset purchase program.
The interest rate decision was powerful and clearly designed to tighten the monetary musculature. The message seemed to be that markets should be aware that the ECB will not hesitate to contain and prepare for inflation. But the TPI (to use the latest acronym) is by far the more consistent step of politics and political economy.
The ECB has made it its mission to prevent government borrowing costs from diverging when it deems them “disorderly” and “unjustified” and affecting its monetary policy stance. In plain language, this means avoiding panic sell-offs in government bond markets if the ECB’s monetary tightening leads investors to wonder what rising interest rates would do to a euro-zone government’s debt dynamics.
These investors have been notified. Lagarde’s press conference hinted that the spread widening the ECB is trying to stop is the self-fulfilling kind, where bond prices fall for no other reason than market participants expect. To put it this way, the ECB will not tolerate market dynamics that, instead of reflecting economic realities, create their own.
And it will intervene to prevent it. The euro has always been particularly vulnerable to the tendency of financial markets to jump from “good balance” to “bad balance” when psychology changes. The TPI is the ECB’s commitment to eradicate the “bad balances”.
The central bank has also taken note of the rest of the EU system of government. The selection criteria rely heavily on the economic policy mechanisms of the European Commission and the Eurogroup of Finance Ministers. To support a country’s bonds under the TPI, the ECB will assess whether its government is adhering to policy recommendations from the Commission and the Eurogroup. It urges elected leaders not to outsource political judgment and urges them to take charge of the decisions that determine whether a country should be protected from speculative attacks.
Without putting it into words, the ECB is belatedly making use of its neglected secondary mandate. This is often forgotten or denied outright, but subject to stabilizing prices, the ECB is legally bound to support the bloc’s broader economic policies. It does so while also reminding everyone who has the authority to set those policies. The responsibility lies with politicians to get their policies in order – but if they do, the ECB will support them and prevent a market panic.
Mario Draghi’s resignation as Italy’s prime minister on the same day that the ECB announced its new tool represents this new decision-making dispensation to a strong degree. The TPI criteria make Italian bonds immediately eligible for TPI when the ECB sees fit holds. This could be short-lived, however, as one of those criteria includes compliance with a country’s EU-funded recovery plan. Draghi said Italy must meet 55 policy measures by the end of the year to remain compliant.
That will weigh on whoever takes over in Rome over the next few months and those in Brussels who need to assess Italian compliance. Precisely by promising to do its part, the ECB has placed more responsibility on the shoulders of politicians.
But the work of the central bank is not over yet. TPI works best as a credible deterrent: a tool you could use, but most likely don’t have to. But Lagarde, oddly enough, wants to keep the markets a bit in the dark: “There are certain components [of TPI] which are best kept unpublished, unpublished and uncommented,” she said. She also volunteered that “we’d rather not use it,” although “if we have to use it, we won’t hesitate.” The second part of this statement would have sufficed. From the looks of it, the ECB will soon be put to the test by the financial markets.
This is an updated version of a previous Instant Insight