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European Central Bank actions face major test as recession approaches

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European Central Bank (ECB) President Christine Lagarde speaks at a press conference following the ECB’s monetary policy meeting in Frankfurt, Germany, July 21, 2022.

Wolfgang Rattay | Reuters

The European Central Bank has tightened its anti-inflationary stance by raising interest rates by 50 basis points and announcing a new anti-fragmentation tool, but analysts are not convinced these measures will solve the eurozone’s many economic problems.

Thursday’s 50 basis point hike was generally well received by the market and commentators as inflation hit record highs in the 19-member single currency bloc and the ECB lags behind its peers in launching monetary tightening. .

However, the aggressive move comes amid slowing growth and risks sparking a recession in the economy as external pressures from the war in Ukraine and related concerns over energy supply remain largely unabated.

The unexpected decline in the July eurozone PMI (Purchasing Managers’ Index) on Friday will only reinforce these fears. Capital Economics said the new data showed “the euro area is teetering on the brink of a recession due to a sharp drop in demand and rising costs.”

The Frankfurt institution also launched the Transfer Protection Instrument (TPI), an anti-fragmentation tool aimed at supporting countries with large debt burdens and high borrowing costs, such as Italy, and limiting disparities among eurozone member states.

“There is a danger that the ECB is crossing the line in funding governments here, endangering its independence and imposing the wrong fiscal and economic policy incentives.”

Clemens Fuest

President of the Ifo Institute

The ECB said the TPI could be activated to counter “unreasonable, erratic market dynamics that pose a serious threat to the spread of monetary policy in the euro area.”

Details released later on Thursday indicated that the tool could be used when some countries see borrowing costs rise due to factors beyond their control, as long as those countries adhere to “prudent and sustainable fiscal and macroeconomic policies.” “.

However, the vagueness of the application of the new tool and its place in the modern function of monetary policy have raised more questions than answers from many analysts.

TPI – addressing the symptom, not the cause

Clemens Fuest, president of Germany’s Ifo Institute for Economic Research, said in a statement Friday that he welcomed the unexpectedly large hike in the key interest rate but criticized efforts to narrow the gap between countries’ borrowing costs.

“Interest rate differentials are part of a functioning capital market because they reflect different levels of risk, and private investors need to be persuaded to take those risks,” Fuest said.

“There is a danger that the ECB is crossing the line in funding governments here, endangering its independence and imposing the wrong fiscal and economic policy incentives.”

He argued that if individual member states run into financial difficulties, it is not the ECB that should intervene, but the euro area governments and the ESM (European Stability Mechanism) bailout fund.

ESM has provided funds to support countries such as Spain, Greece, Portugal, Cyprus and Ireland in recalibrating their finances since its inception in 2012 through loans and other forms of financial assistance.

“The conditions set by the ECB that a country must fulfill in order to receive financial support from the ECB are significantly weaker than the conditions of the OMT bond purchase program introduced during the euro crisis, which requires at least an ESM program with far-reaching conditions,” Fuest added.

He suggested that, unlike the OMT (Direct Money Transaction) program, under which, under certain conditions, the ECB makes secondary purchases of sovereign bonds issued by eurozone member states, the ECB is not bound by any decisions of other institutions in its TPI. program, making it vulnerable to political pressure to provide fiscal support to indebted member states.

Fuesta’s skepticism was echoed by Svetlana Singh, a senior economist at Cardano, who said in a note on Thursday that the TPI rollout is subject to “a lot of ECB-style constructive ambiguity.”

“Eligibility, activation and termination criteria are open to the judgment and discretion of the General Counsel. The timing of the TPI announcement coincided with the widening of BTP-Bunds spreads amid heightened political instability in Italy and raises some interesting questions,” Singh said.

“In the absence of specific details, we think markets will be testing by the ECB and while TPI approval has been unanimous, implementation will be rife with concerns about cash funding.”

Sveta Singh

Senior Economist, Cardano

The spread between Italian and German bond yields is seen as a measure of stress in European markets or an indicator of fear, and has widened in recent months to its highest level since May 2020.

Renewed political instability in Italy after the resignation of Prime Minister Mario Draghi, giving way to new national elections on September 25, further undermined investor confidence.

Singh said the key questions will be whether the ECB will act when spreads widen due to political concerns, as they are now, and how the Governing Council will determine “unreasonable” spread widening.

“In any case, we believe TPI will address the symptom (wider spreads, higher risk premium) rather than the cause (major differences in competitiveness, growth potential, debt levels, fiscal management) and may have a muted effect. by keeping spreads low for longer,” she said.

“In the absence of specific details, we think markets will be testing by the ECB and while TPI approval has been unanimous, implementation will be rife with concerns about cash funding.”

“The real test will come when conditions worsen to the point where the ECB is forced to use TPI, which they hope its very existence will prevent.”

Dean Turner

Chief Eurozone Economist, UBS

However, despite the vagueness surrounding the TPI statement, several analysts have deemed it “credible” for now.

Spyros Andreopoulos, senior European economist at BNP Paribas, said in a note Thursday that the TPI “looks credible to us over the medium term, based on a combination of ECB discretion and no prior restraints.”

“However, the activation threshold is likely high, which suggests that markets can still test the ECB in the short term,” he added.

UBS chief eurozone economist Dean Turner and head of credit Thomas Wacker also acknowledged the lack of details, but said “the overall TPI plan appears to have bought the ECB enough credibility in the eyes of investors.”

“The real test will come when conditions deteriorate to the point where the ECB is forced to use TPI, which they hope its very existence will prevent,” UBS said.

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