European Central Bank (ECB) President Christine Lagarde speaks during a news conference following the ECB’s monetary policy meeting in Frankfurt, Germany, July 21, 2022.
Wolfgang Rattay | R
The European Central Bank tightened its anti-inflationary stance with a 50 basis-point rate hike and announced a new anti-fragmentation tool, but analysts aren’t convinced these measures will deal with the eurozone’s myriad economic challenges.
Thursday’s 50 basis point hike in interest rates was largely well received by the market and commentators, as inflation in the 19-member bloc was at a record high and the ECB lagged behind its peers in initiating the process of monetary tightening.
However, the aggressive move comes amid slowing growth and the risk of the economy slipping into recession as external pressures stemming from the war in Ukraine and related energy supply concerns show little sign of abating indicates.
An unexpected drop in the euro zone PMI (Purchasing Managers’ Index) for July on Friday will only add to these concerns. Capital Economics said the new data suggests “the eurozone is on the brink of recession on falling demand and rising costs.”
The Frankfurt-based institution has also launched the Transmission Protection Instrument (TPI), an anti-fragmentation tool aimed at helping nations with high debt burdens and high borrowing costs, such as Italy, and limiting discrepancies between eurozone member states.
“There is a risk that the ECB will cross the line of state financing, jeopardize its independence and set the wrong incentives for fiscal and economic policy.”
Clemens Fuest
President, ifo Institute
The TPI can be activated to “counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area,” the ECB said.
Details released later Thursday showed the tool could be used if certain countries see rising borrowing costs due to factors beyond their control, provided those countries had adhered to a “sound and sustainable fiscal and macroeconomic framework.” policy”.
However, the unclear application of the new tool and its place in today’s monetary policy function have raised more questions than answers for many analysts.
TPI – Treating the symptom rather than the cause
Clemens Fuest, president of Germany’s Ifo Institute for Economic Research, said in a statement on Friday that he welcomed the surprisingly large increase in the key interest rate but criticized efforts to limit the differences between different nations’ borrowing costs.
“Interest rate differentials are part of a functioning capital market because they reflect different levels of risk, and private investors need to be persuaded to take those risks,” Fuest said.
“There is a risk that the ECB will cross the line of state financing, jeopardize its independence and set the wrong incentives for fiscal and economic policy.”
He argued that it is not the ECB’s job to intervene when individual member states run into financial difficulties, but that of eurozone governments and the ESM (European Stability Mechanism) bailout fund.
Since its inception in 2012, the ESM has disbursed funds to help countries like Spain, Greece, Portugal, Cyprus and Ireland rebalance their finances through loans and other forms of financial assistance.
“The conditions defined by the ECB that a country must meet in order to receive financial support from the ECB are significantly weaker than those of the OMT bond purchase program introduced during the euro crisis, which requires at least one ESM program with far-reaching conditions”, added Fuest.
He suggested that unlike the OMT (Outright Monetary Transactions) program – under which the ECB makes secondary purchases of eurozone member state government bonds under certain conditions – the ECB is not bound by decisions of other institutions in its TPI program, which it is vulnerable to political pressure to offer fiscal support to indebted member states.
Fuest’s skepticism was shared by Shweta Singh, senior economist at Cardano, who said in a note on Thursday that the deployment of the TPI is subject to “a whole lot of ECB-style constructive ambiguity.”
“The eligibility, activation and termination criteria are all subject to the discretion and discretion of the General Counsel. The timing of the TPI announcement coincided with the widening of BTP Bunds spreads due to heightened political instability in Italy and raises some interesting questions,” Singh said.
“In the absence of specific details, we believe markets will test the ECB and while approval of the TPI was unanimous, implementation will be fraught with monetary financing concerns.”
Schweta Singh
Lead Economist, Cardano
The spread between Italian and German bond yields, seen as a measure of stress in European markets – or fear – has widened in recent months to the highest level since May 2020.
Renewed political instability in Italy following the resignation of Prime Minister Mario Draghi, making way for further national elections on September 25, has further damaged investor confidence.
Singh said the key questions are whether the ECB would act if policy concerns caused spreads to widen, as is the case now, and how the Governing Council would define an “unwarranted” spread widening.
“In any case, we believe that the TPI addresses the symptom (widening spreads, higher risk premia) rather than the cause (underlying differences in competitiveness, growth potential, debt levels, fiscal governance) and may have a muted impact on the impact of longer low spreads hold,” she said.
“In the absence of specific details, we believe markets will test the ECB and while approval of the TPI was unanimous, implementation will be fraught with monetary financing concerns.”
“The real test will come when conditions deteriorate to the point where the ECB will have to use the TPI, something they hope its very existence will prevent.”
Dean Turner
Eurozone Chief Economist, UBS
Despite the vagueness surrounding the TPI’s motion, several analysts initially deemed it “credible.”
Spyros Andreopoulos, senior European economist at BNP Paribas, said in a note on Thursday that the TPI “appears to us credible in the medium term due to the combination of ECB discretion and no ex ante limit”.
“However, the activation threshold is likely high, suggesting that markets could still test the ECB in the short-term,” he added.
Dean Turner, UBS’s chief eurozone economist, and Thomas Wacker, head of credit, also acknowledged the lack of detail, but said that “the broad outline of the ECB’s TPI seems to have given enough credibility in the eyes of investors.” .
“The real test will come when conditions deteriorate to the point where the ECB will have to use the TPI, something they hope its very existence will prevent,” UBS said.