Christine Lagarde proclaimed a “rather historical moment” on Thursday after the European Central Bank’s rate-setters unanimously agreed to create a bond-buying tool the ECB president hopes will stop higher interest rates from sparking a new eurozone debt meltdown.
By giving itself the power to buy unlimited amounts of the bonds of any country that it judges to be suffering from an increase in its borrowing costs beyond the level justified by economic fundamentals, the ECB has addressed a key vulnerability haunting eurozone policymakers ever since a debt crisis almost ripped the single currency apart a decade ago.
The idea to tackle big gulfs in the borrowing costs of member states had initially received a frosty reception from officials in frugal countries, such as Germany and the Netherlands, which were worried the central bank would encourage profligacy among weaker countries and could stray too close directly financing governments — a practice that is illegal under EU law.
In the end, officials were rushed into finalising the new instrument sooner than they would have liked by a sell-off in Italy’s bond market, which deepened this week after the country’s prime minister and former ECB president Mario Draghi resigned, triggering a widening spread between yields on the debts of Rome and Berlin.
How did the ECB reach an agreement?
Lagarde said it was “gratifying” when all 25 governing council members backed the creation of the transmission protection instrument, or TPI — a tool which she said would be “critical to properly transmit our monetary policy going forward”.
Analysts suspect a classic European compromise was struck, with the hawkish members of the ECB council succeeding in their push for a bigger than expected interest rate rise of half a percentage point in return for their support on the TPI.
“It looks like a grand bargain,” said Holger Schmieding, chief economist at German investment bank Berenberg. “The proverbial hawks of the ECB prevailed with their demand for a 50 basis point rather than a 25 basis point rate [rise] today; the doves got a new line of defence against an excessive widening of yield spreads within the eurozone.”
How will the instrument work?
The ECB said it would primarily buy government bonds with maturities between one and 10 years of any countries “experiencing a deterioration in financing conditions not warranted by country-specific fundamentals”. What that means in plain English is that policymakers can react to any market pressure on member states — other than that caused by changes in the economic outlook. As part of this, it could also consider purchasing private sector securities “if appropriate”.
There are very few limits on the scale of these purchases — their size will “depend on the severity of the risks” and not any pre-agreed limit. Lagarde said the ECB’s governing council would decide when to use the new instruments “under its own discretion” and without “being dependent on anyone”.
The ECB claimed any bond purchases made under the scheme would not bloat its close to €9tn balance sheet, but it was vague about how exactly this could be done.
Are there conditions attached?
The ECB’s previous purchases of sovereign bonds have been challenged repeatedly in Germany’s constitutional court and there are almost certain to be similar moves against its latest plan. To protect itself, the ECB has attached some relatively light conditions to the new tool.
All 19 eurozone countries will automatically be eligible for the instrument, as long as they have not fallen foul of the EU’s fiscal rules and are meeting the conditions attached to the EU’s recovery fund. The ECB will also consider if a country’s “trajectory of public debt is sustainable” and if it has “sound and sustainable macroeconomic policies”.
Before activating the new tool, Lagarde said the council would assess “market and transmission indicators”, such as the cost of borrowing for governments and businesses, to determine if the impact of its monetary policy decisions was having the desired impact across the region and would then judge whether buying bonds would be “proportionate” in pursuing its 2 per cent inflation target.
Will this help Italy?
Most analysts do not believe the ECB’s new tool will be of much use if Rome falls into a deep self-inflicted political crisis — for instance, if a new government refuses to carry out the structural reforms agreed as part of the EU recovery fund.
When asked about Italy, Lagarde said: “Political matters are for the democratic process of each and every member state and that is certainly the case for the country you are referring to.” She added that “differences in local financing can legitimately arise”, suggesting that the ECB would not intervene if it judged investors to be responding to justified concerns about the direction of Italian economic policy.
If Italian bond yields steadily rose “amid lingering uncertainty over the election results, the ECB could decide not to activate the TPI”, said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.