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Monday, August 15, 2022

Why the ECB is playing with fire

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The European Central Bank (ECB) has simultaneously clouded the economic outlook for the eurozone and created an instrument that can help deal with the fallout. Its President, Christine Lagarde, announced a surprise 0.5% interest rate hike last Thursday while unveiling a new tool to shield a country from speculative attacks. The implications of the first decision are clear; the consequences of the second are more elusive.

The first hike in the ECB’s key interest rate since 2011 has doubled the initial 0.25% hike the central bank announced a month ago. That was the price the hard wing of its board of regulators demanded in order to accept the creation of the Transmission Protection Instrument (TPI), a commitment to buy the bonds of countries exposed to “unjustified and disordered market dynamics.”

The criteria for introducing this tool are so loose that any member of the eurozone could benefit from it. Lagarde defended himself against ECB hawks who wanted countries benefiting from the plan to commit to specific economic policies under the oversight of the European Stability Mechanism, the eurozone’s bailout fund. The ICC’s flexibility and looser terms give Lagarde and other governors the freedom to decide when to let financial markets impose discipline on member states and when to roll back on it.

The potential of the new TPI will depend on being able to activate it quickly. That will not be clear for a long time. The ECB will only consider using them after it has reinvested maturing bond proceeds from the €1.7 trillion bond-buying program it launched during the COVID-19 pandemic.

No doubt investors will test the limits of the ECB’s resolve, probably starting with Italy. Italian 10-year bond yields have risen to 3.5% from 1.2% at the start of the year. The extra yield, which investors need to hold Italian bonds against German equivalents, rose to more than 2.2% on Thursday as markets reacted to Prime Minister Mario Draghi’s resignation.

Lagarde has stated that she prefers not to use the TPI. Although the rate hike will have little immediate impact on inflation, it could accelerate the upcoming economic slowdown. In this regard, the ECB is playing with economic fire as it unwinds the hose.

Source elpais.com

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