The Covid pandemic prompted a massive fiscal response across the developed world and major central banks unveiled further monetary stimulus, which in the ECB’s case took the form of additional bond purchases (the PEPP) and the provision of long term funding to the banking system on attractive terms (TLTRO III). Central banks as a group were also of the view that the pick up in inflation through 2021 was ‘transitory’ and therefore did not require monetary tightening.
Inflation at the time of the ECB meeting last December was 4.9% and the Bank forecast an average inflation figure of 3.2% for 2022, with a fall back below the 2% target the following year. It did signal that the PEPP would end in March but that its maturing holdings would be reinvested till end-2024 while no end-date was set for its Asset Purchase programme. Reinvestments from the latter would continue for ‘an extended period’ after the first rate increase.
The invasion of Ukraine added further upward pressure on elevated energy prices, notably natural gas, and inflation in Europe and elsewhere consistently surprised to the upside, prompting the ECB to respond in June by signalling rate increases to come, albeit still buying bonds till the end of that month.A quarter point increase in ECB rates was pre-announced for the 21 July meeting, with another rate increase to follow in September, although the latter could be higher depending on the inflation performance. The Governing Council also anticipated ‘that a gradual but sustained path of further increases in interest rates will be appropriate’. The accompanying forecasts projected a gradual fall in inflation to 3.5% next year and 2.1% in 2024, with the decline due to ‘moderating energy costs, the easing of supply disruptions related to the pandemic and the normalisation of monetary policy’.
Longer term market rates have moved higher in anticipation of monetary tightening , although expectations have been volatile , fuelled by fears of a global recession; 5-year euro swap rates spiked to 2.20% a month ago, from zero in early February, but have fallen back since, declining to 1.5% before a recent rise to 1.75%. Government bond yields have also risen but not in a uniform manner, with Italy in particularly seeing a significant widening in spreads to Germany. The ECB views this as ‘fragmentation’ and promised to announce a policy tool to counter it on top of using PEPP reinvestments in a ‘flexible manner’, meaning using the proceed of an Irish bond maturity, for example, to buy more Italian debt.
Today’s ECB meeting was surprising on a number of fronts. First, President Lagarde announce a 50bp rise in ECB rates instead of the signalled quarter point, citing the recent inflation data and the weakness of the euro. Second, forward guidance on rates has been abandoned, with a ‘meeting-by-meeting approach to interest rate decisions’, meaning that the September rate decision is now open. ‘Further normalisation will be appropriate’ but she refused to be drawn on what a ‘normal rate’ might look like. Gone also was the previous reference to maintaining ‘ optionality… gradualism and flexibility in the conduct of monetary policy’ although one could argue they were mutually exclusive anyway.
The new anti-fragmentation tool duly appeared with yet another acronym – TPI or Transmission Protection Instrument. This has no set limits and can buy public sector debt from 1-10 year maturities ‘to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area’. Eligibility is conditional though on a given country pursuing ‘ sound and sustainable fiscal and macroeconomic policies’ including complying with the European Commission’s country specific recommendations on fiscal policy and recovery and resilience plans for the Recovery and Resilience Facility.
So in effect the ECB is becoming an enforcer of the EU’s fiscal rules, as was indeed envisaged a decade ago with the creation of Outright Monetary Transactions (OMT).. That required strict fiscal surveillance under an ESM adjustment programme and was never actually triggered so this could be considered OMT lite, with the ECB again as fiscal enforcer but with longer maturity purchases ( OMT was out to 3 years).
One area left vague in the TPI announcement was how the ECB will ‘sterilise’ any bond buying to avoid raising its existing bond holdings or adding to the already huge excess liquidity in the system. That detail will be very significant for the market and as yet there has not been a significant reaction in terms of the euro or interest rate expectations.