By Yanick Loirat, PhD
Eurozone monetary policy normalization is likely here – with the potential need for a new twist.
After years of very accommodative monetary policy to protect eurozone integrity and to compensate for the lack of fiscal support to counter multiple crises (COVID-19 being the latest), the time has come for the European Central Bank to normalize its policy. Inflation has risen to very elevated levels, mainly due to energy prices and supply chain bottlenecks exacerbated by the zero-COVID policy in China and by Russia’s invasion of Ukraine.
The Pandemic Emergency Purchase Program (PEPP) was completed in March, and the Asset Purchase Program is expected to end in the coming months, although their reinvestments will continue for an extended period. Because inflation is running hot, the market expects the ECB to accelerate tightening following actions by the U.S. Federal Reserve. In that context of rising yields, the ECB may need a backstop to prevent market fragmentation and to protect the economies of fragile countries.
Jean-Claude Trichet’s Securities Market Program (SMP), launched to ensure the liquidity of some countries’ debts on certain financial market segments, and Mario Draghi’s Outright Monetary Transactions (OMT), i.e., purchases under conditionality of some government bonds with one- to three-year maturities in the secondary market, are not particularly effective solutions when the issue is the rise of debt costs due to ECB rate hikes. Neither are the Targeted Long-Term Refinancing Operations that facilitated the transmission of monetary policy to the economy with a reward for banks to lend. In our view, flexible PEPP reinvestments should be natural candidates even if they cannot be considered as a backstop: Greater flexibility is still not dedicated only to the fragmented countries.
The ECB cannot impose a threshold on a spread without being pledged into the state funding. To counter spread widening, the central bank should be ready to buy very large amounts of bonds, and to be effective, it needs to be able to deviate from the ECB’s capital key (limiting proportional support to individual countries) significantly more without conditionality.
If the European Union were to unveil a new large-scale joint issuance program comparable in size to the Next Generation EU plan (€500bn plus new EU issuance), peripheral spreads could tighten strongly. But in the meantime, the new tool may be announced jointly with the coming lift-off. That said, we expect it to take longer, given that current spreads do not yet justify an announcement, and because the short end of peripheral curves is not yet under pressure.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.