ECB transmission protection instrument needs a ‘user manual’

Euro area anti-fragmentation scheme requires clarity in four key areas

The European Central Bank’s transmission protection instrument to limit divergences in borrowing costs allows for sterilised purchases of sovereign paper to prevent cross-country interest rate spreads from reaching unspecified unwarranted levels. The TPI, announced on 21 July, does not aim at influencing overall euro area monetary conditions, but at preserving the effectiveness of monetary policy in individual countries: protecting the ‘monetary policy transmission mechanism’ (MTM).

The TPI was launched together with a 0.5 percentage point interest rate increase, larger than expected. That’s no coincidence: the TPI aims to allow higher interest rates while soothing concerns over turbulence in higher-risk sovereign markets. The necessary compromises over the TPI, and the haste in assembling them, have left important details unspecified. These are now under discussion by Eurosystem committees and national central banks. The ECB needs to formulate a TPI ‘user manual’ to clear up any vagueness which could complicate its activation.

The new programme bears some resemblance to the outright monetary transactions, launched in 2012 when Mario Draghi was ECB president. Although it was never used, many observers credit the OMT for having saved the euro area from collapse. Both programmes aim at limiting sovereign interest spreads and have no pre-set maximum for bond purchases. Both programmes were justified, with different nuances, by the need to preserve the functioning of monetary policy.

The main technical difference is that the OMT foresees bond purchases in the short-term (one to three years) whereas the TPI could stretch up to 10-year residual maturity. The main political difference is that OMT activation must be preceded by the respective country reaching an agreement with the European Stability Mechanism, in the form of a credit line, either ‘precautionary’ or fully-fledged with an accompanying adjustment programme. By contrast, the TPI relies on an autonomous judgement by the ECB, based also on elements provided by the Commission, the ESM and the International Monetary Fund.

For the TPI to work, a user manual is essential. We propose these main ingredients.

First, like the OMT, TPI intervention should focus on the short side of the interest rate structure, which matters most for monetary policy transmission. In 2012-22, with interest rates stuck close to the zero lower bound, monetary policy departed from the normal mechanism of working via a chain of interest rate impulses in different market segments. With net bond purchases ended and interest rates headed above zero, normal MTM, centred on interest rates passing through to bank lending conditions, will now be restored. The TPI should be used sparingly, mitigating risks of turbulence when there is clear evidence that short-term spreads are excessive, risking a lopsided MTM. In the same context, it will be important to keep the conditions of banks under scrutiny. With its quarterly bank lending survey and much supervisory information at its disposal, the ECB has all the information it needs for effective monitoring.

Second, the relationship between the TPI and OMT should be clarified. Christine Lagarde, ECB president, has underlined that the OMT was meant to deal with ‘redenomination risk,’ (the threat that one or several countries could leave the monetary union or that the system as a whole could collapse). The TPI should deal with the risk of ‘unwarranted’ risk spreads damaging MTM. However, Lagarde has been silent on the relationship between the TPI and OMT. We think the TPI should be used first. Countries with sustainable economic conditions wishing to pre-empt risks should be encouraged to obtain an official ‘certification’ of this fact from the ESM, applying for a precautionary line which, under ECB guidelines, can open the way to unlimited intervention via the OMT. Countries with deeper economic and financial imbalances should approach the ESM for a credit line, based on an adjustment programme which, if adhered to, would also open the way to OMT. The distinction between the two ESM facilities should be clear, at least in principle. While the PCL aims at protecting the country from unwarranted market speculation (unwarranted because the country’s economy and finances are sustainable), an ESM-sponsored adjustment programme aims at correcting fundamental imbalances.

Third, an important point, not yet specified, is whether the risk (and returns) of TPI purchases will be borne individually by the NCBs, hence indirectly by the respective sovereigns, or will be shared according to the ECB capital key. This is not a technical detail but an important design feature, with large economic consequences. The burden-sharing of central bank operations affects national sovereign risk, hence potentially the cross-country asymmetry of MTM. The logical conclusion is that, if the TPI is focused on protecting MTM, and related bond purchases are confined mainly to the short-term segment, then the costs and risks of such purchases should be shared. This was intended to be the case for the OMT and is usual practice for all monetary policy-related operations.

Fourth, the ECB has indicated that MTM will be protected from Covid-19 risks first and foremost by a ‘flexible’ pandemic emergency purchase programme-related reinvestment policy. Lagarde has called this ‘the first line of defence’. In June-July this year, PEPP reinvestments have been 100% in securities from countries facing higher rates, particularly from Italy, revealing that the ECB has been selectively intervening to close these countries’ spreads. The ECB has not explained the reasoning behind this extreme concentration of ‘flexible’ reinvestments, including, crucially, whether this is linked to the pandemic. Lagarde has stated that the difference between the TPI and unbalanced PEPP reinvestments is that the latter should be motivated by the aim of mitigating pandemic effects. The ECB should clarify that this condition still holds. The combination of ‘flexible’ PEPP reinvestment and the TPI should not go as far as significantly reducing over time the free float of high-yielding securities, which would dry up market liquidity. The ECB must avoid being caught in a ‘fiscal trap’ where it needs to finance a sovereign because of a lack of a proper market for its securities.

Today, there is a lower risk of euro-wide crisis than in 2010-12. The euro area economy has improved significantly since 2012. Intra-area external imbalances have largely disappeared. Market risks are now essentially concentrated on one country: Italy. Other countries previously under financial stress – for example, Spain and Portugal – now are subject to much smaller interest spreads. Even Italy’s conditions have improved significantly in some respects (for example, bank solvency and non-performing credit ratios), though the public debt to gross domestic product ratio is higher and political risks may resurface after the fall of Mario Draghi’s government.

One the other hand, the TPI must work in a radically different economic environment. Inflation is way above target. Monetary policy must become increasingly restrictive to fulfil the ECB’s price stability mandate. The TPI will function satisfactorily only if the rules of engagement are clear: its user manual should be agreed as soon as possible, and made public, in time for the next governing council meeting on 8 September.

Ignazio Angeloni is part-time Professor at the Schuman Centre of the European University Institute, Senior Policy Fellow with the Leibniz Institute for Financial Research SAFE at Goethe University Frankfurt, and former Member of the ECB Supervisory Board. Daniel Gros is a Member of the Board, Distinguished Fellow and former Director of the Centre for European Policy Studies.

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