The writer, former head of the IMF’s European department, is chief economic adviser at Morgan Stanley
After yet another nasty inflation surprise last month, and with European Central Bank president Christine Lagarde no longer ruling out interest rate hikes in 2022, financial markets have got the message that policy tightening is afoot. Long-term rates have started rising across the eurozone, especially in Italy and Greece, where risk spreads have risen to their highest since the outbreak of the pandemic (165 and 230 basis points, respectively).
While it is right that interest rates should rise to cool demand and prevent high inflation from becoming entrenched in expectations, the process may prove to be messy. This is because the ECB, which meets this week, has repeatedly said it will not raise policy rates until it has ended its sovereign asset purchase programme. Officially, there is no terminal date for the programme. In practice, however, the ECB began tapering purchases this month, and markets have been given the sense that the programme underpinning low and stable bond spreads since 2015 will end by early summer.
Given the current low levels, there is certainly room for interest rates and spreads to rise. But it is also important that spreads be bounded in some way — not least because spiking and volatility in them impede the transmission of monetary policy across the eurozone.
As things stand, there are three paths to monetary tightening.
First, the ECB could quickly conclude asset purchases and accept higher long-term interest rates and spreads, and tighter financial conditions; near-term policy rates could be raised shortly thereafter. This strategy could work — but only so long as that other anchor of European stability, head of Italy’s national unity government Mario Draghi, remains in place. A change in the circumstances could easily lead to a spike in spreads in many periphery countries.
Second, the ECB could ditch its self-imposed constraint that quantitative easing must end before rates rise. The rationale for this sequencing is that higher rates contract demand, while continued asset purchases stimulate it — so pursuing both at once sends conflicting economic and market signals, akin to driving with one foot on the brake and the other on the accelerator.
The concern over mixed signals and uncertain macroeconomic effects is exaggerated. For one, the ECB would be raising policy rates from negative levels, which — on account of banks’ traditional reluctance to pass on these rates to retail depositors — would probably have only limited effect, and so should not be very disruptive at the start. Thereafter, nothing would prevent the ECB from calibrating rate hikes and asset purchases such that the net effect is contractionary. Moderate asset purchases, of say €20bn-€30bn a month, may suffice to maintain stability in bond markets, while allowing a net tightening in monetary conditions. It is not unheard of for central banks to engage in opposing transactions in near-term and long-term assets: the US Federal Reserve has done so more than once with its Operation Twist.
Third, eurozone governments could relieve the ECB of the burden of keeping a lid on sovereign spreads. The most straightforward way of doing so would be to create a centralised fiscal facility, like the EU’s coronavirus recovery fund, providing loans and grants to member states facing temporary difficulties. Although the ECB is credited with having kept sovereign spreads low and stable during the pandemic, much of the credit is due to the recovery fund, which is a more tangible signal of European political and economic solidarity than emergency ECB action can ever be. Access to such a facility must come with some safeguards. But the conditions should not be as onerous as the adjustment programmes required by, say, the ECB’s Outright Monetary Transactions facility, which is a political non-starter in countries such as Italy.
This option would be the most sensible economically, both facilitating the near-term need for monetary tightening and addressing the long-term gap in the eurozone’s financial architecture. It would also have the benefit of separating monetary considerations from financial stability concerns, allowing the ECB to focus on its core inflation mandate. The upcoming reform of the Stability and Growth Pact is an opportunity to make a centralised fiscal facility a reality, possibly with a more rigorous standard of fiscal probity if member countries so choose.
While the case for monetary tightening is becoming urgent, the best solution economically is for now not politically realistic. That being the case, the ECB should drop its current guidance on the sequencing of monetary tightening. The worst thing it could do would be to ignore political and economic realities and simply proceed full speed ahead with the termination of asset purchases and the raising of ECB policy rates.