Although you might not have realized it from Christine Lagarde’s low-key delivery, the European Central Bank has become much more pugnacious towards financial markets and fiscal policymakers in the euro zone over the past week.
For some time, the ECB, which Lagarde heads, has been visibly uncomfortable with being “the only game in town”. It has long been left to the central bank to push monetary policy close to its limits to support aggregate demand. And to find legally watertight mechanisms to stop speculative attacks on the integrity of the euro and maintain the solvency of its members.
By deciding last week to raise interest rates half a point higher than announced and to introduce a new “Transmission Protection Instrument” bond-buying program, the central bank of the euro has reversed the situation.
The rate decision was hard-hitting and clearly aimed at flexing some monetary muscle. The message seemed to be that the markets should be aware that the ECB will not hesitate to rein in inflation and prepare. But the TPI (to use the last acronym) is by far the most consequential political and economic political movement.
The ECB has taken it upon itself to prevent the divergence of sovereign borrowing costs, if it deems such divergence “disorderly” and “unwarranted”, and to interfere with the stance of its monetary policy. Put simply, this means avoiding panic selling in the sovereign debt market when monetary tightening by the ECB has investors wondering what rising rates would do to the debt dynamics of a Eurozone government. .
These investors have been put on notice. Lagarde’s press conference suggested that the widening of spreads that the ECB seeks to stop is of the self-fulfilling type, where bond prices deteriorate for the sole reason that market participants expect they do. We could put it this way: the ECB will not tolerate market dynamics which, instead of reflecting economic realities, create their own.
And he will intervene to prevent this. The euro has always been particularly vulnerable to the tendency of financial markets to go from a “good balance” to a “bad balance” when the psychology changes. The TPI is the ECB’s commitment to eradicating “bad balances”.
The central bank also warned the rest of the EU governance system. The eligibility criteria are largely inspired by the economic governance mechanisms of the European Commission and the Eurogroup of Finance Ministers. To consolidate a country’s obligations under the TPI, the ECB will examine whether its government complies with the policy recommendations of the commission and the eurogroup. It’s telling elected leaders not to outsource political judgments, challenging them to take ownership of the decisions that determine whether a country should be protected from speculative attacks.
Without saying it in so many words, the ECB is belatedly using its neglected secondary mandate. This is often overlooked or outright denied, but subject to price stabilization, the ECB is legally bound to support the general economic policies of the bloc. It does so while simultaneously reminding everyone with the power to determine those policies. It is up to politicians to get their policies in order – but if they do, the ECB will support them and prevent market panic.
The resignation of Mario Draghi as Italian Prime Minister on the same day that the ECB announced its new instrument highlights this new dispensation from decision-making. The TPI criteria make Italian bonds immediately eligible for the TPI if the ECB deems it appropriate. But that could be short-lived, as those criteria include meeting a country’s EU-funded recovery plan. Draghi said Italy must complete 55 policy actions by the end of the year to remain compliant.
This will weigh on who takes over in Rome in the coming months, and on those in Brussels who must assess Italian compliance. Precisely by promising to do its part, the ECB has placed more responsibility on the shoulders of politicians.
The work of the central bank is not finished, however. The TPI will work best as a credible deterrent: an instrument you could use but probably won’t have to. But Lagarde, oddly, wants to keep the markets somewhat in the dark: “There are certain components [of TPI] best kept unpublished, undisclosed, uncommented,” she said. She also said that “we’d rather not use it”, although “if we have to use it, we won’t hesitate”. The second part of this statement would have sufficed. As things stand, the ECB should be tested by the financial markets for too long.
martin.sandbu@ft.com
This is an updated version of a previous Instant Insight
