Can the ECB raise rates aggressively given the Fragmentation risk?

The Euro has a fundamental flaw in that member states have fiscal sovereignty but not monetary sovereignty, which is the exclusive preserve of the ECB. Unlike say the UK or the US, EA governments cannot print money in order to fund fiscal deficits if markets are unwilling to buy that debt. As we saw in 2010, that inability precipitated a full-blown existential crisis for the single currency, which was eventually resolved by a changing of the guard in Frankfurt and Draghi’s ‘whatever it takes’ pledge a decade ago..

That involved the creation of bond buying programme known as Outright Monetary Transactions (OMT) designed to buy the bonds of member states where yields were deemed too high and therefore impairing the full transmission of monetary policy-‘fragmentation’ in the ECB lexicon. Access to OMT was to be at a price though-fiscal discipline, with member state eligibility dependent on fiscal retrenchment.

In the event OMT was never used but in 2015 the ECB embarked on QE, buying the bonds of all member states in an effort to combat the risk of deflation. The ECB now holds €5,000bn in bonds ‘for monetary purposes’, about 41% of EA GDP, including €1,700bn from its PEPP programme introduced in 2020. QE is essentially an enormous Swap transaction, in that the ECB receives fixed interest rate coupons on the bonds it holds while paying a floating rate to banks on their reserves, created by the ECB. That makes the ECB vulnerable as rates rise on those reserves.

The ECB is now faced with an inflation problem, which has accelerated far faster than most expected,consistently exceeding ECB expectations. Indeed, in last week’s staff forecasts, inflation was expected to peak in May at 7.5% but a footnote to the forecast acknowledged that the May figure (released after the forecast cut-off point) had been 8.1%, with the expected average for the year now seem as above 7%.

The Bank has now indicated it will tighten policy by raising rates, starting in July and then September, but had already committed to reinvesting PEPP holdings till end-2024, with the €3,300bn QE holdings also reinvested, this time for an ‘extended period’ after rates had started to rise. So it is still injecting huge liquidity into the monetary system while raising the cost of credit.

The prospect of higher short term interest rates has pushed up longer rates, as one might expect, but not evenly across the EA. German 10 year bonds currently yield 1.60% from -0.40% six months ago, a rise of 200bp, while Italian yields are now up at 4%, having risen by 310bp over the same period. Italian debt amounts to 150% of GDP and so a prolonged period of yields that high, or even higher, alongside limp growth, will push the debt burden up in the absence of much tighter fiscal policy. The latter is difficult politically at the best of times but more so now in the face of calls for much greater support for households struggling with the explosion in energy costs. Ireland seems to be out of the firing line, in that the spread with bunds has only increased by around 25bp, with the yield at 2.30%.

  How will the ECB combat fragmentation? Initially via the PEPP it would seem, with Lagarde emphasising flexibility in reinvesting the existing holdings across jurisdictions. Further, we are told ‘ the ECB will deploy either existing adjusted instruments or new instruments that will be made available’ It’s hard to see what other instruments could mean other than bond purchases (the OMT or an expanded PEPP?) which in effect would amount to intervening when yields have breached some target level. Deciding on that target is another issue of course but would in any case mean the ECB would be trying to control both short term rates and longer term rates.

There is also the issue of legality. The ECJ deemed QE as within the ECB’s mandate but there are fresh challenges to the PEPP, which does not have issuer limits. A clear peak in inflation over the next month or so might help to calm things down but the fragmentation issue raises the question of whether the ECB can tighten aggressively if in doing so it risks triggering another full-blown euro crisis.