The writer, former head of the IMF’s Europe department, is chief economic adviser at Morgan Stanley
After yet another nasty inflation surprise last month and European Central Bank President Christine Lagarde no longer ruling out an interest rate hike in 2022, financial markets have received the message that a tightening policy is in progress. Long-term rates started to rise across the eurozone, particularly in Italy and Greece, where risk spreads reached their highest level since the outbreak of the pandemic (165 and 230 basis points respectively).
While it is only right for interest rates to rise to cool demand and prevent high inflation from becoming entrenched in expectations, the process can be complicated. Indeed, the ECB, which is meeting this week, has repeatedly declared that it will not raise its key rates until it has ended its sovereign asset purchase programme. Officially, there is no deadline for the program. In practice, however, the ECB began to scale back its purchases this month, and markets felt that the program supporting low and stable bond spreads since 2015 will end in early summer.
Given the current low levels, there is certainly room for interest rates and spreads to rise. But it is also important that the spreads are limited in one way or another, not least because their soaring and volatile nature impedes the transmission of monetary policy in the euro zone.
As things stand, there are three paths to monetary tightening.
First, the ECB could conclude asset purchases quickly and accept higher interest rates and long-term spreads, as well as tighter financial conditions; short-term policy rates could be raised soon after. This strategy could work – but only as long as that other pillar of European stability, the head of Italy’s national unity government Mario Draghi, remains in place. A change in circumstances could easily cause spreads to spike in many peripheral countries.
Second, the ECB could abandon its self-imposed constraint that quantitative easing must end before rates rise. The reason for this streak is that higher rates contract demand, while continued asset purchases stimulate it – so pursuing both at once sends conflicting economic and market signals, like driving with one foot on the brake and the other on the accelerator.
Concern about mixed signals and uncertain macroeconomic effects is overblown. On the one hand, the ECB would raise policy rates from negative levels, which – due to the traditional reluctance of banks to pass these rates on to retail depositors – would probably only have a limited effect and should so not be very disruptive at the start. Thereafter, nothing would prevent the ECB from calibrating rate hikes and asset purchases so that the net effect is contractionary. Moderate asset purchases, say €20-30 billion per month, could be sufficient to keep bond markets stable, while allowing for a net tightening of monetary conditions. It is not uncommon for central banks to engage in opposing transactions in short-term and long-term assets: the US Federal Reserve has done this more than once with its Operation Twist.
Third, eurozone governments could relieve the ECB of the burden of maintaining a ceiling on sovereign spreads. The easiest way to do this would be to create a centralized fiscal facility, like the EU’s coronavirus recovery fund, offering loans and grants to member states facing temporary difficulties. Although the ECB is credited with keeping sovereign spreads low and stable during the pandemic, much of the credit goes to the recovery fund, which is a more tangible signal of European political and economic solidarity than an action of ECB emergency can never be. Access to such a facility must be accompanied by certain guarantees. But the conditions shouldn’t be as onerous as the adjustment programs required by, say, the ECB’s Securities Monetary Facility, which is a policy non-starter in countries like Italy.
This option would make the most economic sense, both to meet the short-term need for monetary tightening and to fill the long-term void in the eurozone’s financial architecture. It would also have the advantage of separating monetary considerations from financial stability concerns, allowing the ECB to focus on its core inflation mandate. The next reform of the Stability and Growth Pact is an opportunity to implement a centralized budgetary facility, possibly accompanied by a more rigorous standard of budgetary probity if the member countries so wish.
As the case for monetary tightening becomes urgent, the best economic solution is currently not politically realistic. That said, the ECB should abandon its current guidance on the timing of monetary tightening. The worst thing it could do would be to ignore political and economic realities and simply forge ahead with halting asset purchases and raising key ECB rates.