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How the ECB plans to keep markets in check as it hikes rates

A first line of defense against a sovereign-debt crisis akin to the one that struck the euro zone last decade became active on Friday.
Christine Lagarde. Image: Bloomberg

Less than three weeks before embarking on a series of interest-rate increases, the European Central Bank is honing its plans to keep government-bond markets from panicking as it does so.

A first line of defense against a sovereign-debt crisis akin to the one that struck the euro zone last decade became active on Friday. A new instrument to avoid so-called fragmentation — unwarranted blowouts in member states’ yields — is due soon to enable the ECB to respond to record inflation.

Here’s what we know about the central bank’s two-pronged strategy:

Reinvesting pandemic-era bond holdings 

Goal

  • The ECB is determined to convince investors before rate hikes start that it’s serious about ensuring an orderly normalisation of monetary policy.

How it will work

  • The ECB will redirect the proceeds of maturing debt from the 1.7 trillion-euro ($1.8 trillion) portfolio it accumulated during the Covid-19 crisis to vulnerable countries like Italy, where yields surged last month.

Size

  • An average of 17 billion euros of bonds from the Pandemic Emergency Purchase Program expires each month. About 12 billion euros is from stronger nations and can be used to help struggling ones.

Allocation

  • The ECB is so far allowing wide leeway in deploying the funds. It’s said to have divided countries into donors — including Germany, France and the Netherlands, recipients — consisting of Italy, Greece, Spain and Portugal, and neutrals.
  • Stricter rules on who gets what may yet follow, determined by the size and speed of any shifts in yields. Greece, whose debt doesn’t qualify for the regular quantitative-easing program, may get an outsized share if needed.

Time frame

  • PEPP reinvestments are scheduled to run until 2024, though that deadline can be extended. Front-loading — allocating funds before securities have matured — isn’t being allowed for now.

Anti-fragmentation instrument

Goal

  • The tool will offer a more permanent solution allowing the ECB to raise rates as needed in a monetary union where fiscal policies diverge. “We will ensure that the orderly transmission of our policy stance throughout the euro area is preserved,” President Christine Lagarde said in June.

How it will work

  • Government bonds will be purchased when the yields of member-states are deemed to have risen in a way that isn’t justified by their economic fundamentals.

Timing

  • Proposals are being drawn up for the Governing Council to “consider” at the July 20-21 meeting. The wording leaves open the option to postpone a decision if action isn’t considered urgent or more work is required.

Size

  • Officials want a backstop with maximum potency — so it may never be used, like the program created alongside former ECB President Mario Draghi’s 2012 pledge to do “whatever it takes” to save the euro. The upshot could be a plan that’s unlimited in size
  • The now defunct 2010 Securities Markets Program failed to rein in the region’s debt crisis — partly because it had limits.

Balance-sheet impact

  • With other monetary stimulus now being removed, the ECB wants to avoid swelling the money supply with its latest initiative
  • It could do so either through so-called liquidity-absorbing operations — where banks receive interest for parking money at the central bank for a set period of time; or, by selling other bonds in its portfolio — such as those of core countries like Germany.

Conditionality

  • There are likely to be strings attached to avoid accusations the ECB is financing governments outright, though they’ll probably be less stringent than in Draghi’s 2012 Outright Monetary Transactions plan, which required bailout programs no government was willing to request.
  • Conditions could include meeting targets and milestones set out in the European Union’s pandemic recovery plan, adhering to certain fiscal rules, or both. The complication here is that the bloc’s thresholds are currently suspended and some ECB officials are wary of having to judge national fiscal policy.

Legal issues affecting both

  • Faced with law suits on earlier ECB programs, asset purchases were ruled to be within the central bank’s remit partly because they were evenly distributed across the region — something that wouldn’t be the case here.
  • Policy makers have already stressed that whatever they’ll decide will be proportionate, focusing on a term Germany’s constitutional court used when it challenged the ECB’s 2015 QE plan.
  • That means any defense will probably be built around the argument that bond-buying is necessary for the ECB to fulfill its primary objective — preserving price stability across the euro zone.
© 2022 Bloomberg

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