The ECB’s other inflation problem

The fear of fragmentation

As the ECB is getting ready to tighten monetary policy, the Italian sovereign spread increased by around 200 basis points – the level of early 2011. This raises once again the risk of fragmentation as some countries might experience a significant widening of their spreads disconnected from economic fundamentals.

In this commentary, Jens van‘t Klooster argues that the ECB has most of the tools needed to avoid fragmentation. But he warns that when the borrowing costs of governments in weaker eurozone economies surge relative to those of Germany, simply reinvesting the portfolio of the ECB’s existing pandemic emergency purchase program (PEPP) will not suffice and policymakers’ thinking here remains unclear. In addition, to make sure that the hiking rates should not undercut long-term green investments, the ECB should also do more to differentiate refinancing rates and collateral policies. To that end, the ECB should tighten the criteria for its targeted longer-term refinancing operations (TLTROs), which provide low-cost funds to banks that lend to the real economy.
The ECB’s Interest-Rate Balancing Act
By: Jens van‘t Klooster – University of Amsterdam

What tools to avoid fragmentation?

In this paper, Claeys et al. discuss the tool the ECB needs in order to avoid fragmentation as it hikes interest rates. They argue that this tool will have to neutralize the effect of higher interest rates on the spreads of the most vulnerable countries, and therefore this tool needs to be country specific. Could outright monetary transactions (OMT) be that tool? It is country specific and the European Stability Mechanism (ESM) program that is required to accompany it provides political legitimacy. But the OMT/ESM framework is designed to be a measure for when there is a high probability of a solvency crisis while now, a tool is needed for non-debt-crisis times. In addition, the reluctance of countries to use the Pandemic Crisis Support instrument, an ad-hoc ESM tool with minimal conditionality, highlights the belief that the ESM involvement is politically toxic. In addition, Claeys et al. argue, much like Jens van‘t Klooster does, that reinvesting PEPP assets will not be enough. Instead they propose:

• A new tool that would allow the whole risk-free yield curve to move upwards in sync with short-term policy rates, while keeping country spreads in check. And it should be applied, or at the very least decided, in conjunction with interest rate hikes in a consistent framework that aims to neutralize the risk of fragmentation. Two pre-conditions would be necessary for a country to use this tool: a) the country’s debt will have to be sustainable, and for that country to commit to maintain sound policies for its debt to continue to be sustainable in the future; and b) the analysis and confirmation by the European Commission  of the sustainability of the country’s debt from a technical perspective, which would then be approved politically by a majority of the Eurogroup or the Council.
• The ECB needs to rethink its collateral framework in order to abandon its counterproductive reliance on private ratings, which creates some unnecessary uncertainty over the safe-asset status of European sovereign bonds.

Fragmentation risk in the euro area: no easy way out for the European Central Bank
Authors: Grégory Claeys, Maria Demertzis, Lionel Guetta-Jeanrenaud
From: Bruegel