The ECB is raising rates, but it is also committed to buying more government bonds
The European Central Bank (ECB) raised interest rates for the second time this year (by 0.75 percent). The eurozone’s CPI was 8.9 percent in July. In that month, the ECB raised rates by 0.5 percent and created a new instrument of monetary policy, the Transmission Protection Instrument (TPI), to counter the ‘risk of fragmentation’ of the eurozone.
The ECB key interest rates are the Main Refinancing Operations Rate, the Marginal Lending Facility Rate, and the Deposit Facility Rate. These rates were at 0.5 percent, 0.75 percent, and 0 percent, respectively, after the first rate hike in July. And now they are at 1.25 percent, 1.5 percent and 0.75 percent.
The ECB’s balance sheet was just above €8.8 trillion by the end of June. And, in the beginning of July, it slightly decreased, standing at €8.7 trillion on September 9th.
Since 2015, the ECB has not significantly reduced its balance sheet at any time. And, since 2014, it has kept interest rates artificially low, at 0 percent (in the case of the Main Refinancing Operations Rate), close to 0 percent (in the case of the Marginal Lending Facility Rate), and negative (in the case of the Deposit Facility Rate).
Chart 1 – Eurozone Interest Rates and ECB’s Balance Sheet (2012-2022)
Main Refinancing Operations Rate (Red Line, Left Axis); Marginal Lending Facility Rate (Green Line, Left Axis); Deposit Facility Rate (Yellow Line, Left Axis); ECB balance sheet (Purple Line, Right Axis).
Source: St. Louis Fed.
The PTI is a new asset purchase program, focused on bonds of the most indebted eurozone members. As duly noted by Ryan McMaken, this is essentially a new type of QE. In order to buy these bonds, the ECB will have to increase the monetary base. It remains to be seen if the increase in the monetary base arising from this program will be accompanied by a significant increase in M1 and M2 (which are the monetary aggregates that really influence prices in the real economy).
QE, by itself, does not cause prices in the real economy to increase, but it is harmful to the economy by generating distortions in the allocation of resources, making the economy more fragile (more dependent on artificially low interest rates) and susceptible to recessions. These distortions cause resources to be wasted on unprofitable ventures (such as zombie companies), preventing the generation of sustainable ventures and reducing real wages (since indebtedness increases and more money is spent on interest to finance the debt, instead of investing in productivity, which would tend to lower prices and increase real wages). Furthermore, QE makes the prices of financial and real estate assets artificially higher.
The purpose of the PTI is to mitigate the eurozone’s ‘fragmentation risk’. For example, if the interest on Italy’s 10-year government bond (Italy has a debt of 150.8 percent of GDP) was to increase much, it would increase the probability of Italy’s exit of the eurozone (returning to the Lira and expanding the money supply to finance the government debt). This is the so-called ‘fragmentation risk’.
The PTI, therefore, is a form of ‘yield curve control’. Of course, it’s not official, but the effect is similar. The Bank of Japan (BoJ) has been doing a ‘yield curve control’ since 2016: the BoJ does not let the interest on Japan’s 10-year government bond be higher than 0.25 percent. The BoJ buys these bonds, increasing their prices and, consequently, lowering their interest rates. And this is precisely what the ECB intends to do.
Interest rates on 10-year eurozone government bonds have been on an upward trend YTD. The PTI’s goal is to lower interest rates (mainly the ones of the most indebted members), if necessary.
Chart 2 – Interest Rates on 10-Year Government Bonds of Some Eurozone Members
Greece (Blue); Italy (Orange); Portugal (Grey); Germany (Yellow); France (Green); Netherlands (Purple); Ireland (Pink); Spain (Black).
Source: Trading View.
Yes, the PTI also has some eligibility requirements that are supposed to be followed by eurozone members in order for the ECB to buy their bonds under this program. However, we know that governments tend not to follow rules. And countries such as Portugal, Spain, Italy and Greece (which have higher indebtedness and more spendthrift governments) are very dependent on the eurozone’s moral hazard, which does not generate incentives for the most indebted governments to reduce their debt enough for the interest on their bonds to decrease without the intervention of the ECB. At best, in general, governments decrease their debt very gradually (as Portugal did in 2016-2019, and in 2021 after a significant increase in 2020). If governments really followed public debt sustainability rules, the PTI wouldn’t even need to exist.
Furthermore, the euro has been devaluing against the US dollar since 2021 and reached parity 1/1 at the end of August, oscillating close to this level since then. This is another factor influencing the rise of the eurozone’s CPI, as a devalued currency makes imports more expensive.
The Governing Council stated that it “stands ready to adjust all of its instruments within its mandate to ensure that inflation stabilises at its 2 percent target over the medium term.” It also stated that it expects the CPI to remain above 2 percent for an extended period, estimating that the rate (excluding food and energy products) will reach 3.9 percent in 2022, 3.4 percent in 2023 and 2.3 percent in 2024. However, it also stated that the PTI “is available to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across all euro area countries.” In other words, the ECB states that it is willing to pursue a contractionary monetary policy to bring the CPI back to the target of 2 percent while committing to use the PTI (which, depending on the intensity of its use, can counteract the decrease of the CPI) if the contractionary monetary policy prevents eurozone members from financing their high debts.
Like the Fed, the ECB doesn’t have much room to raise rates and shrink its balance sheet (unless these governments significantly reduce their debts). The ECB is being a little less expansionist on the one hand (by making slight increases in interest rates in relation to the high CPI) and may be expansionist on the other (by creating the PTI). Like the Fed, the ECB is just pretending to fight the high CPI. The fact that the ECB’s balance sheet has stopped increasing and that eurozone’s M2 is increasing at a slower pace than in 2020 and 2021 are factors that reduce the pressure on price increases, but this only means that, best case scenario, the ECB will be able to bring the CPI to lower levels. It is less likely that prices will return to pre-2021 levels. This would require a price deflation.
To really get prices to pre-2021 levels, governments would have to reduce their spending, so that their indebtedness would decrease, and the ECB would not only stop expanding the monetary base to buy government bonds, but also shrink its balance sheet (to contract the money supply). Artificially low interest rates are not the only inflationary factor.