The European Central Bank turns the tables on panicked markets and policy makers
While you might not have realized it with Christine Lagarde’s under-appreciated delivery, last week the European Central Bank became even more controversial towards both financial markets and eurozone fiscal policy makers.
For some time, the European Central Bank, which Lagarde chairs, was clearly uncomfortable with being “the only game in town”. The central bank has been left for too long to push monetary policy close to its limits to maintain aggregate demand. And finding legally deterrent mechanisms to stop speculative attacks on the integrity of the euro and to maintain solvency among its members.
When it decided last week to raise interest rates half a percentage point higher than indicated and introduce a new “Transfer Protection Instrument” bond-buying program, the euro central bank turned things around.
The interest rate decision was strong and obviously aimed at flexing some of the frayed monetary muscles. The message seems to have been that the markets should realize that the ECB will not hesitate to rein in inflation and prepare themselves. But TPI (to use the latest acronym) is by far the most important political movement and political economy.
The European Central Bank has taken it upon itself to prevent divergence in sovereign borrowing costs, if it sees such divergence as “disorderly” and “unjustified” and to interfere with its monetary policy stance. In plain words, this means avoiding a sell-off in the sovereign debt market when the monetary tightening of the European Central Bank leads investors to question what higher interest rates could do to the Eurozone government’s debt dynamics.
These investors have been notified. Lagarde’s press conference suggested that the widening of the spread that the ECB seeks to stop is the kind that is self-fulfilling, with bond prices plummeting for no other reason than market participants expect them to do. One could put it this way: the ECB will not tolerate market dynamics that, instead of reflecting economic realities, create their own.
It will intervene to prevent it. The euro has always been particularly vulnerable to the tendency of financial markets to jump from “good balance” to “bad balance” when psychology changes. The indicator of trade profit is the European Central Bank’s commitment to rooting out the “bad balance”.
The central bank also notified the rest of the European Union’s governing system. Eligibility criteria depend heavily on the economic governance mechanisms of the European Commission and the European Group of Finance Ministers. To support state bonds under a TPI, the European Central Bank will consider whether its government is sticking to the commission policy recommendations of the Eurogroup. It tells elected leaders not to outsource political judgment, and dares them to make the decisions that determine whether the country should be protected from speculative attacks.
Without saying it in many words, the ECB has been late to tap into its neglected secondary mandate. This is often forgotten or dismissed altogether, but according to price stability, the European Central Bank is legally obligated to support the bloc’s general economic policies. And it does so while at the same time reminding everyone who has the power to define those policies. The onus is on politicians to arrange their policies – but if they do, the European Central Bank will back them up and prevent market panic.
Mario Draghi’s resignation as Italian Prime Minister on the same day the European Central Bank announced its new instrument puts this new distribution of decision-making in a state of great relief. The TPI criteria make Italian bonds immediately eligible for a TPI if the European Central Bank deems it appropriate. But this could be short-lived, as these criteria include compliance with the EU-funded recovery plan. Draghi said Italy must implement 55 policy measures by the end of the year to remain compliant.
It will affect who will take charge in Rome in the next few months, and those in Brussels who will have to assess Italian compliance. Precisely by promising to do its part, the European Central Bank has put more responsibility on the shoulders of politicians.
However, the work of the central bank itself was not done. TPI will work best as a reliable deterrent: a tool you can use but most likely won’t have to. But Lagarde, oddly enough, wants to keep the markets somewhat dark: “There are certain ingredients [of TPI] which it is better to keep unpublished, unpublished, unannounced.” She also volunteered that “we would rather not use it,” although “if we had to use it, we would not hesitate.” The second part of this statement was sufficient. As it stands, The ECB will likely be tested by the financial markets before too long.
This is an updated version of Previous Instant View