European Central Bank action faces stiff early test as the economy teeters on the brink of recession

 

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

Wolfgang Rattay | Reuters

The European Central Bank toughened its anti-inflationary stance with a 50 basis point hike to interest rates and announced a new anti-fragmentation tool, but analysts are unconvinced that these measures will tackle the euro zone’s myriad of economic challenges.

The 50 basis point increase to the key rate on Thursday was broadly well received by the market and commentators, with inflation running at a record high in the 19-member common currency bloc and the ECB lagging behind its peers in kickstarting the process of monetary tightening.

However, the aggressive move comes against a backdrop of slowing growth and risks tipping the economy into recession, as the external pressures arising from the war in Ukraine and associated energy supply concerns show little sign of abating.

An unexpected contraction of July’s euro zone PMI (purchasing managers’ index) readings on Friday will only serve to further these concerns. Capital Economics said the new data suggests “the euro zone is teetering on the brink of recession due to slumping demand and rising costs.”

The Frankfurt-based institution also launched the Transmission Protection Instrument (TPI), an anti-fragmentation tool aimed at supporting nations with large debt burdens and high borrowing costs, like Italy, and limiting discrepancies among euro zone member states.

“There is a danger that the ECB is crossing the line into financing governments here, jeopardizing its independence and setting the wrong incentives for fiscal and economic policy.”

Clemens Fuest

PRESIDENT, IFO INSTITUTE

The TPI can be activated to counter “unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area,” the ECB said.

Details released later on Thursday showed that the tool could be used when certain countries see surging borrowing costs due to factors beyond their control, providing those countries had stuck to “sound and sustainable fiscal and macroeconomic policies.”

However, the hazy nature of the new tool’s application, and its place in the contemporary function of monetary policy, have raised more questions than answers for many analysts.

TPI – addressing the symptom rather than the cause

Clemens Fuest, president of Germany’s Ifo Institute for economic research, said in a statement Friday that he welcomed the surprisingly large increase to the key interest rate, but criticized the effort to limit the gaps between the borrowing costs of different nations.

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

“There is a danger that the ECB is crossing the line into financing governments here, jeopardizing its independence and setting the wrong incentives for fiscal and economic policy.”

He argued that if individual member states enter financial difficulties, it is not the ECB’s job to intervene, but rather that of euro area governments and the ESM (European Stability Mechanism) bailout fund.

The ESM has disbursed funds to support the likes of Spain, Greece, Portugal, Cyprus and Ireland in recalibrating their finances since its inception in 2012 through loans and other forms of financial assistance.

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

He suggested that in contrast to the OMT (Outright Monetary Transactions) program – in which under certain conditions, the ECB makes secondary purchases of sovereign bonds issued by euro zone member states – the ECB is not bound by any decision from other institutions in its TPI program, which leaves it vulnerable to political pressure to offer fiscal support to debt-laden member states.

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

“The eligibility, activation and termination criterions are all open to judgment and General Counsel discretion. The timing of the announcement of the TPI has coincided with the widening of BTP-Bunds spreads on the back of heightened political instability in Italy and raises a few interesting questions,” Singh said.