ECB Insight: When Push Comes to Shove, Does the ECB Have What it Takes? Maybe.

15 December 2021

By David Barwick – FRANKFURT (Econostream) – Members of the European Central Bank’s Governing Council periodically emphasise their resolve to tighten monetary policy whenever the situation warrants it and without regard for the fiscal interests of euro area sovereigns, but all things considered it would be an optimistic observer who took such assurances at face value.

Still, ECB insiders who spoke to Econostream seemed reassuringly convinced that they truly will walk the walk when the time comes.

To be sure, it is primarily the policy hawks who insist on this point publicly and warn, like German Bundesbank President Jens Weidmann in a speech two weeks ago, of the dangers of Eurosystem central banks having become the largest creditors of euro area governments.

Central banks ‘must be careful not to get caught in the wake of fiscal policy’, Weidmann cautioned. ‘And with sovereign debt high, monetary policy should be wary of any pressure to maintain its very loose stance for longer than the price outlook dictates.’

Although nothing less than the credibility of the ECB is at stake, more dovish Governing Council members aren’t as consistent about stressing this imperative. In an interview late last year with a Greek newspaper, Executive Board member Fabio Panetta was asked whether, when the pandemic emergency purchase programme (PEPP) ended, he was concerned that the sovereign debt of countries like Greece and his native Italy would ‘fall off a cliff’.

Panetta did not seize the opportunity to declare the ECB immune to fiscal or financial dominance. On the contrary, he answered with an exposition that started with the magnitude of the pandemic-related economic contraction, continued with a justification of the ECB policy response and then warned that a weakening of the recovery in the wake of a new wave of infections ‘reinforces the need for prolonged economic support’.

Such an answer might lead a cynical reader to suspect that the point of the mandate is less its actual fulfilment than invoking it to justify ongoing policy support. Of course, one must acknowledge that Panetta was speaking at a relatively early point of the pandemic’s emergency phase, which could help account for his focus on extending rather than withdrawing monetary accommodation.

Not so ECB Vice President Luis de Guindos, who in an interview with a Dutch newspaper just this September was asked whether the ECB’s vast sovereign debt purchases exposed it to the ‘danger of being held hostage by governments’.

Like Panetta a year earlier, de Guindos answered at length, appealing to the extraordinary nature of the crisis as justification for policy accommodation, insisting on the need to prevent fragmentation and then arguing that fears of fiscal dominance were overblown.

Two months previously, de Guindos had been considerably more categorical on the exact same subject in an interview with a German newspaper, which could be understood to mean that the ECB calibrates its rhetoric on critical issues according to the audience.

Curious as to what monetary policymakers really think about the ECB’s ultimate level of willingness to tell euro area sovereigns that the trough they’ve been feasting at is closing, Econostream queried various insiders across the spectrum of monetary policy philosophies. While they readily acknowledged the potential for challenges, none indicated that the ECB would cave in.

‘We all agreed at the strategy review that our objective was price stability, that ultimately we want monetary policy to work in the euro area’, one said. ‘We didn’t have any discussion that went along the lines of, “If we have to tighten, individual economies are going to find themselves in trouble.”’

‘Different people will bring different issues to the table’, he continued. ‘But personally, I cannot see a situation where we conclude that inflation above our target range in the medium term is worth doing, because the alternative might mean that some countries find it hard to pay the interest on their debt.’

‘We are not going to allow inflation in Europe to move beyond our objective, full stop’, he added. ‘We’ll have different views as to what is happening, what’s the outlook, etc. But that particular trade-off we’re not going to make.’

Another insider conceded that it was ‘certainly’ on monetary authorities’ minds what the consequences would be if Italy got into trouble in the wake of tighter ECB policy, but put the burden on fiscal authorities.

‘It is something that needs to be avoided, but for that you need sound fiscal policy’, he said. ‘I don’t mean that you need to balance your budget when you’re still in a downturn, but you need to give a vision that your policymakers are concerned with these issues going forward.’

‘And if I was a fiscal policymaker, my worries wouldn’t be about whether or not the ECB will hike rates gradually at some point in time, it’s whether my sovereign spreads will be contained’, he continued. ‘I would always be more worried about the market perception of fiscal policy soundness than about what happens with monetary policy.’

A third insider characterised the potential for financial or fiscal dominance as ‘a concern’, but insisted that the ECB should resist such dominance and remain focused on its mandate.

We asked a fourth whether he thought it realistic that the ECB would be able in the foreseeable future to extricate itself from QE, given the reliance of certain countries on these purchases.

‘If inflation expectations go higher, then there would be a chance to stop net asset purchases, so I think it is realistic’, he responded. ‘I don’t think it is realistic to assume that we will be able to put a lot of that back on the market, so basically the reinvestment phase will be very long. So maybe no new additions to the portfolio, that can be achievable with higher inflation expectations, but not the reinvestment; that is a long-term business for the ECB right now.’

A fifth ECB insider called the potential in some countries for interest rate payments to rise ‘significantly’ when the ECB starts tightening ‘a risk scenario that any prudent policymaker should consider, and … a potential scenario that could be of some concern, especially for those treasuries that have a high volume of debt, in spite of the fact that I don’t think this is the baseline scenario for the medium term.’

However, he stressed, ‘from the point of view of the ECB, these considerations should not play any role.’ Monetary policymakers ‘have to produce inflation of 2% over the medium term, and all these considerations about the fiscal conditions in some parts of the euro area and so on and so forth should play no role at all.’

Pressed on whether such considerations nevertheless influenced ECB thinking, he replied, ‘Well, they play a role as far as the situation of fiscal policy and public debt and so on are relevant objects for the transmission of monetary policy. Of course. We have to take this into account. But you cannot bias your monetary policy in order to make the life of this treasury or the other treasury easier.’

For good measure, Econostream also spoke to an official within the EU bureaucracy who clearly had reservations about prospects for a smooth withdrawal of monetary accommodation.

‘Over a long period of extremely low interest rates and central bank hoarding of a big chunk of government debt issuance, we have created structures and dependencies that we don’t fully understand’, he said. ‘So we don’t really know the extent to which our economy and financial market actors and bond markets are dependent on the continuation of these policies, and what happens when we start withdrawing them.’

‘There is a tangible risk that the world will be facing quite some difficulties getting back to a more normal constellation of policies, and that will probably mean it’s going to be a protracted process’, he added.

With the day when the ECB will initiate the return to more normal policies potentially no longer in the distant future, monetary policymakers will increasingly confront the question of how to handle the dependency of euro area sovereigns on cheap borrowing costs. More regular public assurances addressing the concerns of Weidmann and others would be an important aspect of the process.