FRANKFURT — Few challenges in the history of the European Central Bank have created more drama than whether it should aim to limit differences in member states’ borrowing costs.
Policymakers resigned in protest and fought in court over the issue. It has earned one ECB president the reputation of “the greatest central banker of modern times” while raising doubts about the competence of another.
The next act is about to begin.
Government bond spreads – the premium other member states pay over Germany’s 10-year risk-free bond – have reached two-year highs. The main fear is that the central bank’s plans to raise interest rates could increase the cost of borrowing in the most indebted countries.
To avoid a further widening of spreads amid policy tightening, ECB President Christine Lagarde said in March that the central bank could “design and deploy new instruments” to ensure that the policy set by the ECB can affect the economies of all Member States in the same way.
As the Governing Council sets the stage for rate hikes later this year, POLITICO takes a look at how the central bank has handled this challenge in the past – and what it has learned to apply in the future.
The Trichet era
The ECB spear its first targeted bond buying program in May 2010, as the escalating sovereign debt crisis caused spreads in highly indebted member states, including Greece and Italy, to soar.
Under then-President Jean-Claude Trichet, the ECB took a hesitant approach, seeking first to ensure that the troubled member states in question would honor their commitments to rapidly reduce public debt levels. That wasn’t enough for Bundesbank chief Axel Weber, who quickly resigned in protest, arguing that the central bank was de facto funding governments, which is illegal under the EU treaty. He also expressed concern that bond purchases would remove much-needed market pressure for governments to get their finances in order.
But the ECB maintained bond purchases and eventually bought Italian debt – even after the country failed to deliver. This prompted Weber’s fellow German on the board, Juergen Stark, to resign.
In retrospect, the success of the first program was considered limited at best, as it failed to sustainably limit borrowing costs for debt-ridden member states. The disappointing results prompted the ECB to launch his next program.
Super Mario intervenes
This effort, dubbed OMT, was announced in September 2012. It brought much more firepower after the famous pledge of the next president, Mario Draghi, to do “everything necessary” to preserve the single currency.
The magic of the OMT was that it promised unlimited remedies – and it worked. The Eurozone has pulled away from the brink and Draghi has been credited with single-handedly saving the Eurozone. As for the ECB, it never had to spend a single penny on bond purchases because the announcement alone was enough to calm the markets.
The UNWTO also demanded more than vague promises from politicians. Instead, its activation was linked to the commitment of governments to implement economic reforms.
Still, the program remained contested. Weber’s successor at the Bundesbank, Jens Weidmann, opposed it, as did many German parliamentarians and academics who questioned the legality of the OMT. After years of legal battle and a scathing opinion from the German Constitutional Court, the Court of Justice of the European Union finally declared its legality in 2015. However, the judges also underlined the importance of certain limits imposed on the ECB , stressing that the central bank must respect the principle of “proportionality” and refrain from distorting market prices.
The ECB’s next challenge was deflation, as a byproduct of anemic growth and structural factors. In January 2015, he announcement the asset purchase program (APP) as a tool to keep inflation close to target. As such, the program was not intended to close the gaps, so it drew far less criticism than its predecessors. It was also important that its design was heavily influenced by the CJEU decision on the OMT: The ECB did not just base its bond purchases on the size of member states’ economies, but imposed limits on how much it could buy of debt from any Member state.
In short, although closing spreads was not the main motivation, it was one of the consequences of the APP. And the ECB’s massive debt purchases have allayed investor doubts about sovereign solvency.
The program is set to be phased out in June, after seven years and €3.2 trillion of bonds added to the ECB’s books.
Rethinking the pandemic
Then the global pandemic hit in 2020. With fears of a global slowdown and urgent expectations of a massive fiscal counter-effort, investors looked for reassuring words that the ECB would support governments and thwart any radical divergence in policy. borrowing costs.
But the opposite happened. famous lagarde declared that the ECB was not there to close the spreads, causing Italian bond yields to jump in seconds. Its reputation in the eyes of the markets never quite recovered, even after it was able to draw up a rescue package a week later which enabled the ECB to close the spreads, the emergency purchase program in pandemic case (PEPP).
The PEPP allowed the ECB to move away from the rules governing the APP and to focus purchases on certain member states, at least temporarily. This time, the program received the full support of all Board members. Since the spreads this time were driven by an outside threat rather than a self-inflicted injury, they agreed the situation was different.
The ECB initially pledged to spend another 750 billion euros on bonds, but by the end of the PEPP last March it had printed 1.7 trillion euros to save the economy.
Aware that the combined effect of the end of asset purchases and rising interest rates could drive bond yields up again – after fiscal bailouts during the pandemic pushed public debt to record lows unprecedented – policymakers are now gearing up for the next act.
Importantly, the question of whether the ECB is there to help manage the spreads seems to have been answered: the ECB pledged in December to maintain flexibility in its purchase programs even after the pandemic.
“Within our mandate, under stressed conditions, flexibility will remain a component of monetary policy whenever threats to the transmission of monetary policy undermine the achievement of price stability,” Lagarde said at the time.
For ECB policymakers, this commitment marked a major shift in philosophy. Lagarde has since reiterated that the central bank could deploy a new tool to counter rising spread levels if necessary, although she did not elaborate further.
For their part, fellow policymakers Olli Rehn and Robert Holzmann have since suggested the Board of Governors could stop hesitating to present a full-fledged weapon.
“If or to what extent the details become public, I don’t know,” Holzmann recently told POLITICO.
There is little objection to the general idea, according to people familiar with the discussion. Even the Bundesbank acknowledges that the OMT, with stringent conditions attached, is not always the appropriate response. In the event of external shocks such as the pandemic, the action of the ECB should not depend on budgetary and structural reform commitments.
Nevertheless, the ECB will probably rely on some past experiences. Most effective was Draghi’s promise to do “whatever it takes”, notes economist Berenberg Holger Schmieding.
“The ECB would have the greatest impact if it did not commit to the details in advance but credibly announce that it would intervene vigorously if necessary,” Schmeiding said – an approach that Bundesbank President Joachim Nagel called it “strategic ambiguity”.
The ECB has not yet decided when and if it will share details of a new tool. Policy makers are currently weighing the pros and cons of introducing such a tool early. An early announcement, such as the OMT, is considered to provide a stronger signal to the markets. The suspension, on the other hand, would allow the ECB to adapt the program to the specific circumstances of any future crisis, making it more effective.
Either way, it’s the commitment, rather than the specific details of such a tool, that really matters.
What financial markets need to know is “we could have it and it would be used if needed,” Holzmann said.
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