One of the ECB’s problems was that it had actually achieved its main purpose without necessarily doing much itself. By this we refer to its statutory objective of ensuring that there is no inflation in the Eurozone. Indeed, it is interesting that the ECB mainly has this objective, in contrast to the “dual” objective of the FED which is inflation and full employment at the same time.
And we say that he achieved it without doing much, because the history of the ECB until very recently coincided with a long period when in the world economy inflation was in a significant decline, to the point of the global financial crisis, that of 2008, which, in unlike that of the 1970s, it did not translate into a spike in inflation.
After all, the very creation of the Eurozone allowed overall lower borrowing costs across Europe and this also made it easier for businesses not to be under great pressure to raise prices.
Moreover, the biggest real challenge facing the ECB, until very recently, was the exact opposite of a burst of inflation: instead it was called upon to prevent a deep recession in the wake of the 2008 crisis, to prevent the weakening of the euro from soaring debt of the “weak links” and to proceed even with a delay in “quantitative easing” practices which he promoted even more in the period of the pandemic in various forms.
Now is the first time that the ECB is faced with the challenge for which it was supposedly created, namely a burst of inflation. Except that things are not that simple: because at the same time he has to deal with a European economy that is very likely to be in recession in the next period. And as you know, economic orthodoxy says that the best way to respond to increased inflation is essentially through the activation of “restrictive” quasi-recessionary dynamics.
This constituted throughout this phase after the increase in inflation a double challenge, which in its aspects is almost contradictory: at the same time to reduce inflation and return to the limits of 2% (which remains the statutory objective of the ECB) and to avoid a great recession in Europe.
The ECB uses other instruments besides interest rates
The ECB thus announced another seemingly impressive increase in its key interest rates by 75 basis points. It seems a lot, but it is good to remember how much interest rates had fallen in a previous phase and also that even increased these interest rates seem quite low if we look at the levels at which inflation is moving today.
And apparently they will continue with further increases as the battle with inflation continues.
However, other aspects of the ECB’s policy are of particular interest, where things are even more complex. Let’s not forget that in successive phases the ECB managed large programs of buying securities, so that there could be liquidity in the market, but also large programs of particularly cheap lending to the banking system, always with the same purpose: to have liquidity and for banks to be able to continue to lend.
But this created a condition where the European banking system was largely built on the certainty of this continued support from the ECB.
But the continuation of these “quantitative easing” policies in practice counteracts any effect that decisions such as raising interest rates will have.
Because the purpose of high interest rates is precisely to “slow down” the economy somewhat, so that businesses do not expand, employees do not consume, so that prices fall. If even with higher prime rates the banking system continues to be able to easily access funding, it is clear that in practice it will not implement “restrictive policy” and will therefore continue to lend, albeit at higher interest rates, which in turn it maintains the inflationary pressure.
But there is always the fear that if the ECB moves too quickly to reverse these programs, it could trigger a banking system backlash that could ultimately lead to much sharper recessionary dynamics or, even worse, a more general banking turmoil. Especially at a time when other aspects of the financial markets, such as the bond markets, are in a phase of significant volatility.
The change of navigation
In this context, the ECB seems to be starting a controlled correction effort beyond raising interest rates.
With regard to the two main asset purchase programs, which have been a key aspect of the European version of “quantitative easing” in the past, the “Asset Purchase Program” (APP) and the “Pandemic Emergency Asset Purchase Program (PEPP) ), the ECB decided not to make any changes, i.e. it will continue to invest and reinvest the amounts from bond redemptions:
“The Governing Council intends to continue to reinvest, in full, the proceeds of the redemption of securities acquired under the APP program at maturity for an extended period of time after the date on which it began to raise key ECB interest rates and, at each case, for as long as it is deemed necessary to maintain conditions of abundant liquidity and the appropriate direction of monetary policy.
With regard to the PEPP scheme, the Board of Directors intends to reinvest the capital amounts from the redemption of securities acquired under the scheme at their maturity at least until the end of 2024. In any case, the future roll-down (roll- off) of the PEPP portfolio will be adjusted in such a way as to avoid interference with the appropriate direction of monetary policy.
The Governing Council will continue to apply flexibility in the reinvestment of amounts from the redemption of PEPP portfolio securities as they mature in order to address risks to the monetary policy transmission mechanism related to the pandemic.”
Where things change is in relation to other financial tools. The most significant change concerns the Targeted Longer-Term Refinancing Operations (TLTRO III). Here the change is that there will be an upward adjustment of the interest rates when they are repaid, usually making them more expensive. This responds to the fear that banks had taken a large volume of funding from the ECB, at extremely favorable interest rates, which now allow them to take advantage of the higher interest rates even on the banks’ reserves at the ECB.
And here the wording is characteristic:
“The Governing Council also decided to amend the terms of the third series of targeted longer-term refinancing operations (TLTRO III). During the acute phase of the pandemic, this instrument made a significant contribution to addressing downside risks to price stability. Today, given the unpredictable and unprecedented rise in inflation, it is necessary to readjust to ensure that it is compatible with the broader monetary policy easing process and to strengthen the transmission of policy rate increases to bank lending conditions. The Board has therefore decided to adjust the interest rates applicable to SPPMA III from 23 November 2022 and to provide banks with additional dates for early repayment on an optional basis.”
And to avoid the risk that the banks will “park” money that they actually borrowed at a very low or even zero interest rate in the Eurosystem and benefit from the higher interest rates, the reference rate for reserves changes and becomes in practice lower: ” in order to achieve a closer alignment of the interest rate on the minimum reserves held by credit institutions in the Eurosystem with the conditions prevailing in the money market, the Governing Council decided to set the interest rate on the minimum reserves at the rate of the ECB’s deposit facility. »
Difficulties are ahead
Christine Lagarde avoided using expressions that would refer to an aggressive “quantitative tightening” policy. He obviously did not use this expression, nor did he explicitly talk about limiting the assets (balance sheet) even though he was asked. He insisted on the vocabulary of adjustment and “smoothing” preferred by the ECB and at worst “future gradual reduction of the portfolio” emphasizing of course that the goal remains the reduction of inflation and referring to subsequent decisions.
Anyway, in a way the landscape is uncharted. The EU has not yet agreed on the plan to reduce the energy state. The scale of recessionary trends is not a given. The war in Ukraine continues with no way out in sight. Problems with seeking increases in productivity continue. Supply chains are entering an already complicated phase if we also consider the escalation of high-tech sanctions against China.
This means that the questions that the ECB is asked to answer, the extent to which it will “balance” the need to reduce inflation with avoiding a deep recession, do not depend only – and in some cases not even mainly – on monetary policy. They are about much more strategic and ultimately political issues.
