The European Central Bank’s action faces severe tests as recession approaches

The European Central Bank toughened its anti-inflation stance with a 50 basis point rate hike and announced a new anti-fragmentation tool, but analysts are not convinced these measures will tackle the eurozone̵[ads1]7;s myriad economic challenges.

Thursday’s 50 basis point hike in key interest rates was largely welcomed by the market and commentators, with inflation at a record high in the 19-member single currency bloc and the ECB lagging behind its peers in kick-starting the process of monetary tightening. .

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

An unexpected decline in July PMI (purchasing managers index) readings on Friday will only help fuel these concerns. Capital Economics said the new data suggested “the eurozone is on the brink of recession due to falling demand and rising costs.”

The Frankfurt-based institution also launched the Transmission Protection Instrument (TPI), an anti-fragmentation tool aimed at supporting nations with heavy debt burdens and high borrowing costs, such as Italy, and limiting divergences between eurozone member states.

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 rising borrowing costs due to factors beyond their control, provided those countries have adhered to “sound and sustainable fiscal and macroeconomic policies.”

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

TPI – addresses the symptom rather than the cause

Clemens Fuest, president of Germany’s Ifo institute for economic research, said in a statement on Friday that he welcomed the surprisingly large increase in key interest rates, but criticized efforts to narrow the gap 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 funding governments here, jeopardizing its independence and setting the wrong incentives for fiscal and economic policy.”

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

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

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

He suggested that unlike the Outright Monetary Transactions (OMT) program – where the ECB under certain conditions makes secondary purchases of government bonds issued by eurozone member states – the ECB is not bound by any decision of other institutions in its TPI. programme, which makes it vulnerable to political pressure to offer financial 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 TPI’s deployment is subject to “a whole lot of ECB-style constructive ambiguity.”

“The eligibility, activation and termination criteria are all open to review and the discretion of the General Counsel. The timing of the announcement of the TPI has coincided with the widening of BTP-Bunds spreads against the backdrop of heightened political instability in Italy and raises some interesting questions,” Singh said .

The spread between Italian and German bond yields is seen as a measure of stress in European markets – or a fear gauge – and has widened in recent months to its highest level since May 2020.

Renewed political instability in Italy after the resignation of Prime Minister Mario Draghi, giving way to a new national election on September 25, has further damaged investor confidence.

Singh said the key questions would be whether the ECB would act when spreads widen due to political concerns, as is the case now, and how the Governing Council would define an “unwarranted” widening of spreads.

“In any case, we believe that TPI is more likely to address the symptom (wider spreads, higher risk premiums) rather than the cause (underlying differences in competitiveness, growth potential, debt levels, fiscal governance) and may have a muted impact on keeping spreads lower for longer, ” she said.

“In the absence of concrete details, we believe the markets will test the ECB and while the approval of the TPI was unanimous, its implementation will be fraught with monetary funding concerns.”

Despite the uncertainty surrounding TPI’s application, several analysts considered it “credible” for the time being.

BNP Paribas senior European economist Spyros Andreopoulos said in a note on Thursday that TPI “looks credible to us over the medium term, based on the combination of the ECB’s discretion and no advance limit.”

“However, the threshold for activation is likely to be high, suggesting that markets may still test the ECB in the near term,” he added.

UBS Chief Eurozone Economist Dean Turner and Head of Credit Thomas Wacker also acknowledged the lack of detail, but said “the broad outlines of the TPI appear to have bought the ECB enough credibility in the eyes of investors.”

“The true test will come when conditions deteriorate to the point that the ECB has to use the TPI, which they hope its existence will prevent,” UBS said.