The ECB's policy normalisation may have ended already

The decision to accelerate policy normalisation in the face of adverse macro risks and restore monetary dominance will prove unwise

The ECB decision this week was eagerly anticipated, not so much because of the decision to hike interest rates but rather because of the announcement of a new asset purchases instruments. It took place against a very specific macroeconomic, geopolitical and internal Italian political context, whose ramifications need to be carefully unpacked.

The ECB announced quite clearly stated that despite its guidance suggesting a 25bps hike, it decided to normalize policy faster because of (i) upward surprises to inflation, (ii) a weaker EUR exchange rate and (iii) the confidence it had in its ability to ensure the transmission of monetary policy thanks to its new Transmission Protection Instrument (TPI).

This latter point is particularly important because it suggests that the new Transmission Protection Instrument enabled faster monetary policy tightening. In practice, the new asset purchase framework of the ECB is now designed to operate with several instruments:

a)     the PEPP designed to address fragmentation caused by the pandemic (through its reinvestment policy that leaves some level of flexibility)

b)    the OMT programme, designed to address redenomination risks. It was interesting to hear the ECB mentioning the OMT, which operates alongside an ESM programme.

c)     The new Transmission Protection instrument to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.

The Transmission Protection Instrument has however important features that suggest that the likelihood of its utilization is limited or at least, that the hurdle for activating it will be very high, a clear win from the most hawkish quarters of the ECB. Indeed, while the TPI can in principle be unlimited and the bonds purchases by the ECB be held on pari passu terms with other creditors to avoid juniorization of the debt that stays in the market, the criteria for authorizing the use of the TPI seem hard to meet or at the very least likely to be subject the following conditions

      I.         Compliance with the EU fiscal framework:

a.     Not being subject to an excessive deficit procedure (EDP),

b.     Not being assessed as having failed to take effective action in response to an EU Council recommendation under Article 126(7) of the Treaty on the Functioning of the European Union (TFEU);

    II.         Absence of severe macroeconomic imbalances:

a.     Not being subject to an excessive imbalance procedure (EIP) or

b.     Not being assessed as having failed to take the recommended corrective action related to an EU Council recommendation under Article 121(4) TFEU;

   III.         Fiscal sustainability building on the debt sustainability analyses by the European Commission, the European Stability Mechanism, the International Monetary Fund and other institutions, together with the ECB’s internal analysis;

   IV.         Sound and sustainable macroeconomic policies:

a.     Complying with the commitments submitted in the recovery and resilience plans for the Recovery and Resilience Facility

b.     Complying with the European Commission’s country-specific recommendations in the fiscal sphere under the European Semester

There are two critical questions here:  

1.     How high the conditionality hurdle to activate this intervention?

The most sensitive point here and one where the ECB needs to exercise judgement is the debt sustainability analysis. The ECB has put itself in the position to determine what is the debt sustainability of the Euro Area’s Member States, which is a wholly circular exercise, because for a country that issues a fairly reputable international reserve currency, debt sustainable so long as the Central Bank deems it to be!

The second more positive development is that because the TPI relies on rules that have proven to be largely defective, it might intensify pressure on the European Commission and European governments to reform them but also radically increases the stakes of such reforms. The ECB could have stated maybe more forcefully than it did here and here what would be a new and more desirable set of rules before using them as a yardstick for a critical policy instrument.

2.     What is the trigger for activating the instrument?

This is a more difficult question because the ECB has been careful to avoid drawing a line in the sand that would be the object of immediate speculation. Instead, it is referring only to disorderly and unwarranted market dynamics (ie. volatility, second moment rather than spread levels) stressing that it considered current conditions as NOT warranting an intervention. The problem here is that despite the formulation, this will invite markets to test what disorderly and unwarranted means?

The internal and external geopolitics

The internal politics of this instrument is that it brings back the ECB as the ultimate judge of debt sustainability, something it has spent the better part of the Euro crisis avoiding by deferring to governments (IMF, ESM, Commission). I think it is wholly misplaced for a central bank to decide whether the government’s debt it owes its existence to is sustainable or not, a leap too far in central bank independence. This attempt to reimpose monetary dominance it feels it has lost, will undoubtedly backfire. Worse, it is tragic to do so while conceding to the hawks a faster pace of normalization. Finally, given the risk of legal challenge to the TPI that will at least for a while cast a shadow over its use, the ECB may have well given it all to the hawks, something that won’t be missed on market participants.

Another critical element of the internal geopolitics of this decision is that it takes place against the backdrop of imploding Italian government. The ECB’s signal here is also clear: “we will not be derailed by the internal political vagaries of any Member States”, even one led by the former President of the ECB. But while a perfectly reasonable decision to make for an inflation targeting central banker, one cannot help but ponder the highly asymmetric consequences of a Meloni-Lega led government in the middle of a high-intensity conflict with Russia.

Indeed, the external geopolitics is perhaps the most concerning. It seems very hard to reconcile the ECB’s hawkish lurch with the growing shadow of a serious European recession provoked by a war of aggression that European governments have wholeheartedly and unanimously described as a battle for Europe’s soul. That the ECB, while paying lip service to the idea of an ongoing war, would choose to tighten policy and make the financing of the war effort more challenging for European governments is somewhat perplexing. An independent agency, whose action would undermine the actions of its government in a situation of war would most likely fundamentally endanger its independence. If war is not a case where the ECB’s secondary objective (supporting the general policies of the Union) should take precedence over its primary mandate, then what is?

All in all, this decision by the ECB will probably go down both as an economic policy mistake for it is tightening policy in the face of impending recession (very much like it was in 2011) but also and maybe more fundamentally as a political mistake as the attempt to restore monetary dominance with the TPI at this point and time, will only provoke a more intense backlash down the road.

The market reaction to this decision suggests all these elements are being taken into account: widening Italian spread, collapsing Bund yield and a somewhat weaker Euro. Pretty much all that the ECB was trying to avoid. The good news is that the hawkish chest-pounding and “normalisation” may not last very long. Bund yield’s peak may well be behind us.