Anti-fragmentation tool: A tricky task for the ECB

Anti-fragmentation tool l ECB | Economy | Inflation | Interest rate hikes | EUR

The spread between the Italian and German 10-year yields rose to well over 200 basis points before the ECB's emergency meeting in mid June. This phenomenon, which is shown in the chart below, is what the ECB is trying to get under control with it's new anti-fragmentation tool.

On 9 June, Christine Lagarde described the problem of fragmentation as follows:

To that end, obviously, we need to make sure that there is no fragmentation that would prevent the adequate monetary policy transmission throughout the entire region. We have existing instruments. I think that we have described them in the past. It is obviously the reinvestment capacity that we have under the PEPP, which is a complete reinvestment package that totals €1.7 trillion, that will be reinvested with total flexibility if warranted across time, across jurisdictions, across products.

She pointed out that fragmentation is avoided to the extent that it would interfere with the transmission of monetary policy and that there are existing instruments to control it. However, she also stated the following at the same time:

If it is necessary, as we have amply demonstrated in the past, we will deploy either existing adjusted instruments or new instruments that will be made available.

This is exactly what happened on 15 June when the new anti-fragmentation tool was announced. Regarding the exact conditions, she said the following:

On the conditions that would trigger the anti-fragmentation: let's be clear, the critical point is monetary policy transmission and we are very attentive to make sure that it transmits throughout the entire euro area. So there is no specific level of yields increase or lending rates or bond spreads that can unconditionally trigger this or that. The principle is that we will not tolerate fragmentation that would impair monetary policy transmission, and we will determine on the basis of circumstances, of countries, how and when that risk is likely to materialise, and we will prevent it.

It is expected that the money spent on buying additional bonds through the new instrument will be withdrawn from the economy elsewhere so that it does not increase inflationary pressure.

Although the details of the program are not yet known, the general idea has to be critically questioned. First of all, it is not a newly emerged problem, just remember the euro crisis in 2010. Whenever there is uncertainty in the markets, Italian bonds spreads rise. An investor demands a higher risk premium on government bonds, a rational market mechanism that the ECB is trying to counter. The underlying problem that countries like Italy have structural economic problems is not solved (to be fair, it is not the ECB's task to solve these structural problems).

The main source of potential fragmentation has to do with divergences of countries’ fiscal profiles and potential growth. Monetary policy can do something, but to minimise the potential risk of fragmentation fiscal sustainability in the long term and structural reforms that enhance productivity and competitiveness are needed. - Lagarde 04.21.2022

But nevertheless, the legitimate question remains: Are these interest rate differences not fundamentally justified?

European Central Bank Governing Council member Joachim Nagel has a similarly critical stance. In his opinion, the use of the new tool is only justified if three conditions are met.

1. if "interest rate spreads are fundamentally unjustified" 2. if monetary policy "transmission mechanism is impaired" 3. if the previous two are "limiting the Eurosystem's ability to maintain price stability in the euro area"

In his view, the danger lies in the following:

"it would be fatal if governments were to assume that the Eurosystem will ultimately be ready to assure favorable financing terms for the member states."

In the current economic situation, the ECB wants to avoid a sharp increase in the borrowing costs of highly indebted countries and at the same time create incentives for a sound fiscal policy. Lagarde admits that the design of the anti-fragmentation instrument is not an easy task:

"have to be effective while being proportionate and containing sufficient safeguards to preserve the impetus of member states towards a sound fiscal policy"

Markets have reacted strongly after the announcement on 15 June and spreads have come back significantly. If the markets' expectations of the new instrument are not met, spreads will revise sharply. Especially in combination with the high inflation and high sovereign debt.

How the ECB will solve this dilemma is questionable; it is very likely that the measure will be financed by countries with good credit ratings, thus keeping spreads low in the short/medium term. In the long term, however, the problems are not solved.

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