Exclusive: Permanent Anti-Fragmentation Tool Not Seen as Essential by Most ECB Insiders

27 May 2022

- ECB insider: We stand ready to react flexibly to fragmentation; ‘forget about specific tools’
- ECB insider: I assume there will be similar provisions for APP as for PEPP reinvestments
- ECB insider: Hiking rates not so risky that we need to prepare for damage control ex ante
- ECB insider: It’s the sovereigns, not the ECB, that need to take care of their spreads

By David Barwick – FRANKFURT (Econostream) – The addition to the European Central Bank’s toolkit of a specific new tool to counter financial market fragmentation retains its attractiveness for some, but ECB insiders who spoke to Econostream recently generally downplayed the subject or regarded it as downright unnecessary ex ante.

As Econostream reported on April 13, such a permanent facility would face potentially difficult obstacles, a fact we suspect is reflected in the ECB’s most recent communication on the subject.

As we noted on Monday, ECB President Christine Lagarde sounded very far in her otherwise bold blog post from being able to tell markets that the ECB is making progress on the creation of such a programme, limiting herself to assurances that the Eurotower’s ability to rise to the occasion is established and will continue to serve it well.

On Wednesday, Executive Board member Fabio Panetta, whose native Italy may have the most at stake of any Eurozone member state, called on the ECB to ‘be ready to intervene as needed to neutralise any non-linear market responses that may arise from raising rates, and to mitigate the impact of an asymmetric tightening of financing conditions within the euro area.’

The ECB should ‘ensure that we are in a position to credibly announce the availability and readiness of such an anti-fragmentation tool’, he said.

Panetta’s somewhat frantic-sounding appeal, coming just as a first rate hike is pencilled in for July, confirms that the idea thus remains alive, but also corroborates our view that an idea is all it still is for now.

One ECB insider appeared to endorse that interpretation, noting that Lagarde had already been ‘very clear’ after April’s Governing Council meeting that ‘flexibility is key for us’ and that ‘we can develop any instrument very quickly and effectively and on a massive scale, like the PEPP [pandemic emergency purchase programme].’

‘From her response it is clear that, look, we stand ready to react, but forget about specific tools - we will keep monitoring developments and if need be, we will be super flexible and super ambitious in the response’, he said.

Still, this person did not categorically exclude that the ECB would eventually come up with something; although Lagarde had ‘completely downplayed this workstream’, he observed, ‘she also said that we will keep improving our toolkit.’

A second ECB insider clearly considered the discussion superfluous, arguing that ‘[w]e have plenty of such facilities already’, such as flexible reinvestment of maturing PEPP purchases and the ECB’s infamous outright monetary transactions (OMTs).

‘Sometimes I wonder what is meant by the instruments that the ECB has in its toolbox’, he said. ‘From my point of view, everything that we’ve done at any point in time is in our toolbox. Because if it could be done then, it can be done in the future. And if that’s not enough, then we will do whatever it takes.’

But it was not as if the ECB were embarking on a perilous venture anyway, he said. ‘I don’t see so much the value of saying that hiking monetary policy is so risky that we need to prepare for damage control ex ante’, he said. ‘I think we can hike rates even without the current tools, easily.’

Should a sovereign face a higher spread in the wake of rate hikes, then ‘the sovereign in question should make it clear that their fiscal policy going forward is going to be sustainable’, he said. ‘And that will hold back the spreads. So, it’s a matter of the specific sovereign, not the central bank that needs to take care of it.’

This would only cease to be the case under very specific circumstances, he said. ‘If it were a market-technical spread increase, then we could do something, but then let’s see exactly what the source of the increase is’, he reasoned. If instead it were a question of debt sustainability, ‘then I guess something like OMT is the only answer’, since the ECB would have to ensure that the sustainability issue is addressed, he said.

Should a new virus come along, ‘then we do a new PEPP’, he said. ‘To me, designing a facility against something is a bit odd.’

A third insider indicated that he and the other Council members would ideally ‘not talk too much about this’, the idea being that ‘if and when it’s needed, we are ready to act, but without the details’, so as not to encourage market speculation.

However, he said, ‘There are provisions in the PEPP reinvestment programme, and there will be similar provisions in the APP [asset purchase programme] reinvestment programme.’

Pressed on the latter point, he replied, ‘I assume so, definitely.’

Asked at the April 14 press conference whether the ECB was ready to apply to APP reinvestments PEPP-style flexibility, Lagarde gave a wordy answer extolling the virtues of flexibility while leaving room for interpretation.

OMTs are another option, albeit ‘the one which everybody avoids mentioning’, this person said. ‘But internally we talk openly about OMTs, so it’s certainly an option for me to address this if and when the spreads get too large.’

A fourth insider suggested that there would be ‘less and less willingness’ to endow the APP with reinvestment flexibility ‘if there is a kind of a backstop mechanism for market stress.’

‘PEPP was exceptional because the pandemic is exceptional, but the APP is not exceptional, it’s a monetary policy tool, a kind of a normal QE tool approved by the European Court of Justice and with a capital key inside’, he said. ‘Since it was rubber-stamped, then nobody would like to touch it. It is more likely that we will deliver a kind of a backstop which is extraordinary and can therefore be judged as something unique.’

The fifth and last insider to whom Econostream spoke on the subject said the ECB had to take into account the ‘fragility of the bond markets.’

‘We have our OMT of course, but I think we need to think about that’, he said. ‘If there is less fragility, it’s easier for the ECB to tighten, that’s clear. And of course, that’s why there’s a need to understand how you can avoid this risk in some jurisdictions where the indebtedness is very high.’

As for flexible reinvestment, ‘it’s not for the APP, and it’s quite short-term and the amounts there are not that big’, he said. ‘It should have some impact, but personally, I’m worried mostly about the political risks. If there’s a smooth tightening cycle, then all the southern countries can cope with that. But if there are political risks at the same time that you have new governments with crazy ideas and markets don’t trust them, then we are in trouble. Hopefully the OMT is the right programme for this kind of uncertainty, because we can’t step in if there are political troubles.’

Econostream asked three of the five insiders whether any particular level of spreads set off alarms at the ECB, and all three said no.

The first insider of those mentioned above reasoned that the ECB shouldn’t be in the business of trying to identify the proper level of spreads based on fundamentals or what level would be unwarranted, all of which varied by country and was subject to change.

‘As Lagarde has said, we should focus on anything that impairs monetary policy transmission’, he said. ‘Or as it is said in the statement, we need to safeguard financial stability, but also the transmission of monetary policy. That could be spreads, but it could be many other things.’

The second insider said that even during the euro area sovereign debt crisis, there had been no specific levels that acted as ‘triggers’ for the ECB.