An old problem could come back to haunt the European Central Bank as it prepares to push interest rates out of negative territory.
The problem is “fragmentation”. Put simply, it is the fear that when the ECB tightens or loosens monetary policy, the effects will not be felt equally across the 19 countries that make up the eurozone – a potentially destabilizing phenomenon.
This is a problem that other central banks generally do not have to worry about. It afflicts ECB policymakers over what the economists at Bruegel, the influential Brussels-based economic think tank, describe as the eurozone’s “peculiar and possibly incomplete institutional framework, with 19 sovereign governments which each have their own fiscal policy but share a currency and a single monetary authority.
Fragmentation, if it were to materialize, could be devastating for the euro area, the Bruegel economists warned, “because financial fragmentation could threaten financial stability and ultimately undermine price stability and euro itself”.
Indeed, former ECB President Mario Draghi’s July 2012 vow to do “whatever it takes” to preserve the euro at the height of the region’s debt crisis came as that fragmentation was fueling fears that the common currency could explode as yields on Italian debt and other securities – stressed eurozone countries rose to unsustainable levels against German and other government bonds .
Why is fragmentation on the radar? Developments in the eurozone government bond market raise red flags.
Bonds are selling off, predictably, as the ECB prepares to end its asset purchase program and lays the groundwork to deliver the first in an expected series of interest rate hikes. interest next month as it battles inflation which has climbed well above its Medium-Term Objective of 2%. The concern, however, is that Italian government bonds, for example, are selling much stronger than their German counterparts.
The spread between Italian 10-year government bond yields TMBMKIT-10Y,
called BTP, and German 10-year government bonds TMBMKDE-10Y,
or dykes, has widened considerably. In other words, investors are demanding a significantly higher yield to hold Italian debt compared to German paper.
These spreads, however, are not yet close to the levels reached during the worst days of the Eurozone debt crisis some 10 years ago. And judging by ECB President Christine Lagarde’s remarks on Thursday, policymakers aren’t worried yet.
But economists are nervous. The gap continued to widen on Thursday after Lagarde offered no details of a so-called gap-fighting tool, instead touting the ECB’s record of rapidly improvising tools to make deal with crises when needed. The ECB also stressed that reinvestments of bonds it purchased under the Pandemic Emergency Purchase Program “can be flexibly adjusted across time, asset classes and jurisdictions. at any time”.
The ECB announced on Thursday that it would end its bond-buying program on July 1 and raise rates by a quarter of a percentage point in July, and signaled that it would likely raise rates by a quarter of a percentage point. half point in September.
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The lack of detail “confirms our view that the ECB will act reactively (as opposed to proactively) to mitigate the widening of sovereign spreads if this threatens the monetary policy transmission mechanism,” said Marco Valli, Chief European Economist at UniCredit Bank, based in Milan. , in a footnote.
“For now, the ECB appears to be quite reckless, increasing the risk that markets will test the central bank,” Valli wrote.
Andrew Kenningham, chief economist for Europe at Capital Economics, said Lagarde’s remarks offered “limited comfort”.
“The Bank’s track record in preventing fragmentation is mixed. And there is good reason to believe that the Governing Council would struggle to agree on how and when to act unless bond markets come under severe strain,” he said. declared in a note (see graphic below). “So it’s no surprise that bond spreads widened further today.”
Kenningham, like Valli, argues that investors are likely to eventually test the ECB’s resolve, meaning the risk of a sell-off in the bond market is high.
What could the ECB do if things went wrong?
The Eurozone debt crisis subsided in 2012 when Draghi led the ECB in crafting an emergency bond-buying program that went well beyond anything the bank had power station had used before and which could be used in an emergency. The program, known as outright monetary transactions, or OMT, has never been used, but its existence and the work to shape it have helped calm the storm as government debt yields most vulnerable in the euro zone returned to sustainable levels.
Bruegel’s economists, in a papersaid the best tool would be country-specific and would be applied “only when the debt sustainability of the countries in question is validated through a political process, and should be applied in conjunction with interest rate decisions.” interest so that the whole framework is coherent.”
The OMT comes closest to these characteristics. The problem, however, is that it is designed for periods when there is a high likelihood of a solvency crisis, they said, whereas a tool is now needed for periods without a crisis.
What is needed, they said, is “a new option with the right economic ingredients and a process to ensure that it is politically legitimate and within the limits set by the treaties of the European Union, but which, unlike the OMT, could be applied in real time to neutralize the additional risk that monetary tightening could pose to certain countries.