Alone again (naturally)

The European Central Bank and its burden

This week has been truly clarifying for the European Central Bank and its watchers. If any doubts still lingered that the ECB could conduct monetary-policy business as usual and ignore the divergent cost of borrowing in the Eurozone’s south, events since the 8-9 June meeting of its governing council have put them to rest.

Coming out of the coronavirus pandemic and into a war between two commodity-producing superpowers, global inflation is hitting levels unseen since the 1970s. Compared to the last decade, when it averaged 1.7% annually across the OECD’s 38 nations, inflation is forecast to peak at 8.5% this year and only ease off to 6% in 2023.

Central banks have a primary mandate – to maintain the value of the currency by suppressing inflation. Yet, while monetary authorities throughout the world have been raising their official interest rates in response to the price-level surge, the ECB has gone no further than to promise a small rate increase in July and another larger one in September.

It has taken these baby steps even though its typically optimistic staff foresees inflation this year at 6.8% and trending down to 2.1% in 2024 compared to a mandate of 2% over a three-year horizon. Worse still, say its critics – before even lifting its deposit facility rate (DFR) for the first time in 11 years – the ECB has been arm-twisted into containing a consequent rise in the market interest rates paid in return for holding Italian, Spanish, Greek and Portuguese government debt.

My friend Richard Cookson was not alone when he wrote in his Bloomberg column: “The ECB has now put itself in an impossible position … For the past 10 years, rather than targeting inflation, monetary policy has been set with a view to keeping its weakest members from leaving the currency union. Bluntly, it is no longer an inflation-targeting central bank”.

I would agree that, from 2011 onwards and especially since it first explored an exit strategy from its most unconventional policies (negative interest rates and bond purchases) in 2018, the ECB’s policy making has been distorted – captured even – by a single member state’s fiscal imbalances. And let’s call a spade una vanga; this is about Italy and no one else.

Where I disagree is over what this single-state fiscal capture meant for inflation targeting over the pre-pandemic decade and what it means for now and the future. Being restrained from fighting rising price pressures during the 2012-19 “lowflation” decade would have been what Mario Draghi, the ECB’s former president, once called a “luxury problem”. More than one ECB official has expressed the opinion that, without Covid, we would still be stuck in the long period of disinflation. It took the shock of the staggered financial and sovereign-debt crises to push us into lowflation, and it has taken the extraordinary shocks of a pandemic and a war to jolt us out.

Now this longed-for conflict between the ECB’s two intertwined mandates – maintaining price stability and preserving the Eurozone – is finally underway, the ECB is choosing to do both. This week’s decision to create a new tool to cap rising Italian interest rates means the ECB is now better equipped to lift the DFR aggressively into 2023 to prevent high current levels of inflation from embedding in expectations and wage settlements.

“Lo spread”

The root of this policy dilemma is the Eurozone’s unique structure as a monetary union with a single currency overseen by a federal central bank while a patchwork of 19 governments each run their own budgets and issue their own debt. As inflation expectations increase, so do market assumptions for short- and long-term interest rates. But not equally. Some government debt is more equal than others.

Take Germany, for example. Last year, as the pandemic started to clear, public debt stabilised below 70% of GDP and the government’s structural budget deficit at 2.5% of GDP, while labour productivity grew 2.8% after a pre-Covid decade averaging 0.9%. Then take Italy, where public debt peaked at 150% of GDP, the structural deficit hit 6% of GDP, and productivity shrank 0.8% after averaging just 0.3% growth from 2010-19.

Contrasting debt dynamics and political cultures mean investors (many of whom are Italian) demand a higher interest rate for their Italian than their German debt holdings, which creates a spread between their bond yields. When the ECB was buying huge volumes of this debt via its quantitative easing (QE) programme in 2015-18 to prevent deflation and via its pandemic-emergency programme in 2020-21, this spread was driven below 100 basis points.

German-Italian 10-year bond spread (Il Sole 24 Ore)

It widened dramatically in 2018 when an anti-system/nativist government refused to comply with the Eurozone’s fiscal rules. After a second spike in 2020 as Covid ripped through Italy and the EU hesitated in response, the spread was compressed by the ECB’s pandemic emergency purchase programme (PEPP). It only began its trend wider from last summer as economies reopened, supply-chain bottlenecks generated inflation and interest rates rose everywhere. However, while German 10-year rates have risen from -0.4% last summer to 1.6% today and French from -0.1% to 2.2%, Italian yields have gone from 0.6% to 3.7% - an eight-year high. Not only are Italian bond rates going up in line with rising global rates, they are getting an extra shove from the ECB’s decision to end QE. From 2015 until July – and especially during the pandemic years – the ECB was a guaranteed buyer of Italian debt. Now the Italian treasury will find out what return the private sector wants for its bonds without the security of the ECB as the buyer of first resort.

This is not a lead-up to Greek-style insolvency yet (I will discuss that Black Swan in a future 24/2 post). Under the ECB’s 2015-21 security umbrella, the Italian treasury took advantage of the low interest-rate environment to extend the average maturity of its outstanding debt beyond seven years. This means that, even though it will have to refinance debt worth more than €400 billion by the end of next year, the government should not run into a funding crisis in the short term at least.

Fixing the transmission

This is an immediate problem, however, for the ECB because these interest rates cascade through the national economy. Government bond yields set a floor for rates on bank loans to companies and households, so their borrowing costs are rising more steeply than those of their competitors in other Eurozone economies. At the same time, since Italian banks hold so much government debt, a rise in its yield (reflecting a fall in its price) chips away at their capital and willingness to lend. This is why Italian bank equity values have fallen 10% since the ECB announced its tightening plans on 9 June compared to an 8% drop for Eurozone banks as a whole.

All in all, this means financial conditions will tighten more quickly and more severely in Italy and, to a lesser extent, in Spain – the Eurozone’s third- and fourth-largest economies – than they will in Germany and the low-debt Eurozone core.

As a result, when the ECB raises its three official interest rates – of which the DFR is currently the most important – the impact will be felt differently across the Eurozone. This could force the central bank to end its intended interest-rate cycle to or beyond “neutral” – an interest rate consistent with technically full employment and price stability – because financial conditions are overtightened in one part of the currency area but not everywhere.

Rather than gearing its strategy to preventing an Italian exit from the Eurozone, it is this hampering of policy transmission that the ECB is seeking to address with its new (promised but not yet unveiled) “anti-fragmentation instrument”. It will not be a “bazooka” like the PEPP, which actively compressed spreads. This new tool will be more like the short-lived securities market programme (SMP), which was created in 2010 to buy Greek bonds and was later extended to Irish, Portuguese, Spanish and Italian securities before its retirement in 2012. Unloved as it was, the SMP got the Eurozone through the first two years of its sovereign-debt crisis. A retrospective study by economists at the Central of Ireland found that the SMP’s “passive interventions” to “stabilise yields” rather than compress them “can generate stability without trying to buck the long-term trend of the market” and this, in turn, “keeps the policy effective for longer”.

So, problem solved. Up to a point. The downside to this kind of programme – and the reason the ECB’s governing council still has to venture beyond its principles into implementation – is that it is so discretionary. At what point does the German-Italian spread stop being justified by economic and fiscal fundamentals and become, in ECB-ish, “unwarranted”? Ignazio Visco, the Italian governor on the council, claims less than 150 basis points – a level unseen since the end of March – is fair value and 200 isn’t. Until the ECB’s skid in the road this week, market consensus was that nothing would flash red in Frankfurt until at least 250.

You had one job

This is where monetary-policy purists start to lose patience. Immediately after the ECB published its statement on Wednesday, I was WhatsApping with my exasperated former colleague Armando Marozzi. "This is ridiculous,” he said. “You can’t leave total discretion on when or where a yield is warranted or unwarranted. You have two options: either you explicitly close the spread and lay the foundation for a common yield in the euro area, or you act as an independent central bank. Let’s forget country dynamics for a second. You are a central bank, and you must carry out monetary policy in the best possible way. You don’t get to talk about reforms; governments do. In my view, it is optimal – given the structure of the euro area – to fix a reference yield, tighten and buy the difference, and then let politics take care of the other stuff. But, if you don’t do the optimal for moral-hazard considerations, you aren’t doing your job. You are reasoning as a politician not as a central banker".

While I’m sympathetic to the clarity such a solution would offer, I plead guilty to political reasoning. In my view, this radical approach of removing market discipline (other than the Eurozone-wide discipline exerted by the new common rate) from Italian governments would only work if fiscal policy were federalised and/or truly rules-based. Eurozone governments operate within a complex set of rules that establish limits for structural deficits and targets for debt reduction, but enforcement is highly politicised and discretionary. In return for eliminating sovereign spreads, market discipline would have to be replaced by realistic and enforced rules.

In my view, the optimal way to have taken away the most acute element of this problem for the ECB would have been to “federalise” the once-in-a-century €1.7-trillion PEPP portfolio and return governments to their pre-pandemic debt positions. Alternative proposals on how this could be done have been published by Emilios Avgouleas and Stefano Micossi and – under orders from French President Emmanuel Macron and Italian Prime Minister Mario Draghi – by Francesco Giavazzi and Charles-Henri Weymuller. But politics takes time, even during emergencies. When speed is required in the Eurozone, only the ECB has the agility and authority to act – as became clear in 2012 (“whatever it takes”) and in 2020, when the PEPP allowed governments to issue emergency debt to cope with the crisis.

At the onset of the pandemic, Vesa Vihriälä suggested the ECB should convert this debt into perpetual bonds with a zero coupon. Anticipating the current predicament, he acknowledged that such debt forgiveness would be dangerous in raising expectations of a repeat performance. “Nevertheless, this moral hazard should be weighed against what is likely to happen without such relief. Either fiscal expansion would fall badly short of what is needed in the highly indebted member states, or it would be financed by ever-increasing asymmetric ECB bond purchases … The marginal financing – and, yes, solvency – of the vulnerable member states would become increasingly dependent on the ECB”.

That is certainly the perception. It will not, I believe, be sustained. I’ll return to this bigger theme soon.