Updated: 2 days ago
ECB l Monetary policy | Economy | Inflation
The following article provides an overview of the ECB's latest monetary policy decision. On the 21st of July, the ECB decided to increase interest rates by 50 basis points and approved the Transmission Protection Instrument (TPI).
The interest rates were raised for the first time in 11 years. The level of the rate hike came as a surprise. The majority of market participants had anticipated an increase of 25 basis points. In short, the explanation for this larger interest rate hike was given as follows:
The Governing Council judged that it is appropriate to take a larger first step on its policy rate normalisation path than signalled at its previous meeting. This decision is based on the Governing Council’s updated assessment of inflation risks and the reinforced support provided by the TPI for the effective transmission of monetary policy. It will support the return of inflation to the Governing Council’s medium-term target by strengthening the anchoring of inflation expectations and by ensuring that demand conditions adjust to deliver its inflation target in the medium term.
In contrast, on the 9th of June it was reported:
Accordingly, and in line with the Governing Council’s policy sequencing, the Governing Council intends to raise the key ECB interest rates by 25 basis points at its July monetary policy meeting.
In more detail, the reasons for the high inflation can be summarised as follows:
Surging energy prices were again the most important component
Food inflation rose further (reflecting the importance of Ukraine and Russia as producers of agricultural goods)
Persistent supply bottlenecks for industrial goods
Recovering demand, especially in the services sector (the full reopening of the economy is supporting spending in the services sector)
Depreciation of the euro exchange rate
Transmission Protection Instrument (TPI)
The second issue addressed was the Transmission Protection Instrument (TPI) . Below is a brief recap of the issue before the new measures are explained.
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.
On the 21st of July, more concrete measures were presented with the Transmission Protection Instrument (TPI). In short, the measures can be summarised as follows:
Subject to fulfilling established criteria, the Eurosystem will be able to make secondary market purchases of securities issued in jurisdictions experiencing a deterioration in financing conditions not warranted by country-specific fundamentals, to counter risks to the transmission mechanism to the extent necessary. The scale of TPI purchases would depend on the severity of the risks facing monetary policy transmission. Purchases are not restricted ex ante.
The ECB gives itself a lot of leeway in the amount and timing of the market intervention. There are also few restrictions in the selection of tradable instruments. Thus, public sector securities (marketable debt securities issued by central and regional governments as well as agencies, as defined by the ECB) and private sector securities are possible instruments. The ECB has defined a number of criteria in order to decide whether the TPI should be applied.
(1) compliance with the EU fiscal framework: not being subject to an excessive deficit procedure (EDP), or 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);
(2) absence of severe macroeconomic imbalances: not being subject to an excessive imbalance procedure (EIP) or not being assessed as having failed to take the recommended corrective action related to an EU Council recommendation under Article 121(4) TFEU;
(3) fiscal sustainability: in ascertaining that the trajectory of public debt is sustainable, the Governing Council will take into account, where available, 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;
(4) sound and sustainable macroeconomic policies: complying with the commitments submitted in the recovery and resilience plans for the Recovery and Resilience Facility and with the European Commission’s country-specific recommendations in the fiscal sphere under the European Semester.
But even here, the choice of words such as "will be an input into the Governing Council’s decision-making" or "will be dynamically adjusted" shows that the ECB has a lot of flexibility in its decision.
These criteria will be an input into the Governing Council’s decision-making and will be dynamically adjusted to the unfolding risks and conditions to be addressed.
Even more critical is the comment by Paul Donovan (chief economist at UBS Global Wealth Management):
The bond market manipulation plan is “we do what we want, when we want.” Conditions are determined by the ECB, leaving market manipulation down to spin, not objective assessment. Bond buying will be sterilized (no money supply increase).
The markets were not very excited about these planned market interventions. The 10y spreads between Italy and Germany rose nearly to the level seen before the ECB's emergency meeting. On Friday the 22nd of July, spreads were trading at 234 basis points.
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