ECB TRIES TO CORRECT ITS MISTAKE

Under pressure, the ECB can and will act. If it has to, it will intervene to prevent excessive market turmoil that might otherwise cause serious economic damage across the Eurozone. But not for the first time, it has taken an adverse market reaction to an earlier ECB decision or comment to force the bank to shift its stance or spell out its intentions more clearly. The risk that the turmoil could get badly out of hand for long seems low, in my view. The risk that markets will remain unsettled for a while is more significant, though.

The backdrop: Last Thursday, the ECB disappointed the expectations which ECB president Christine Lagarde had raised on 23 May. In a blog, she had suggested that the ECB would design and deploy a new tool to prevent what it may deem as an excessive blowout in yield spreads (“fragmentation” in ECB speak) after the end of net asset purchases. On 9 June, the ECB’s formal statement then fell short of this reference to a potential new tool by merely suggesting that “under stressed conditions, flexibility will remain an element of monetary policy whenever threats to monetary policy transmission jeopardise the attainment of price stability”. Spooked also by the Fed’s apparent shift to a more aggressive stance in response to the US inflation rate of 8.6% in May, markets took fright. In a repeat of the dynamic of earlier crises, fear started to feed on fear with higher and higher yields exacerbating concerns about Italian debt sustainability. This, in turn, caused more investors to shun Italian and other peripheral bonds.

Crisis meeting result: Trying to correct its mistake, the ECB has now vowed “to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council.” Last Thursday, such words would probably have made a decisive and possibly lasting difference. The ECB today managed to reverse some of the sell-off. But after the turmoil of the last few days, markets are now more nervous than before. The ECB thus faces a bigger risk that markets may test the ECB’s resolve again soon. The ECB is under pressure to reveal more about such a tool in the near future, either at its July or its September meeting. A strategy of “constructive ambiguity” of telling markets that the ECB would act if need be without providing much further information may still work. But it is less likely to do so than before. The ECB’s pledge to reinvest redemptions within its PEPP portfolio flexibly, perhaps by replacing maturing Bunds by Italian bonds, and doing so well ahead of the actual redemption of the Bund, is helpful. However, the ECB had said that before, including in its statement of 9 June. That alone will apparently not suffice.

Designing a new instrument against market fragmentation is fraught with practical and legal difficulties. Against the backdrop of high inflation, the hurdle for interventions is higher than in times of low inflation. Simply buying more bonds could run against the overall normalisation of monetary policy. Country-specific interventions raise questions about a further blurring of the line between monetary and fiscal policy. To justify such interventions, the ECB may have to explain why a further surge in Italian yield spreads could hinder the transmission of monetary policy to the real economy to such an extent that Eurozone inflation might fall below 2% in the medium-term instead of merely returning to the 2% target. Any tool that the ECB will present will likely face a challenge at the German constitutional court.

The big picture: None of these concerns should distract from the big picture, though. If necessary, the ECB will act. Markets know that a safety net exists. The ECB is a potential lender of last resort. In a deep crisis, a country would have to ask for help from the European Stability Mechanism (ESM) which – in the wake of two huge external shocks (pandemic, Putin) – would likely be granted with minimal conditionality. This would pave the way for the ECB to deploy its big anti-crisis tool (OMT). The issue at stake now is how and under which conditions the ECB would already intervene before any turmoil has escalated to the extent that a country may have to turn to the ESM. More precisely, the debate is about a further line of defence between the somewhat weak first line, the flexible use of PEPP redemptions, and the ultimate OMT backstop.

Holger Schmieding
+44 7771 920377

[email protected]
www.berenberg.com

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