ECB Exits NIRP, Unveils ‘TPI’ On Irony-Laden ‘Whatever It Takes’ Anniversary

The ECB hiked rates for the first time in more than a decade Thursday and sketched the contours of a “Transmission Protection Instrument,” the name given to a new “anti-fragmentation” tool aimed at ensuring undue stress in periphery bonds during what the bank imagines will be a long normalization process doesn’t impair the transmission of monetary policy or otherwise threaten what counts as cohesion in the fractious bloc.

The rate hike, 50bps, officially marked the end of negative rates and came after a week of intense speculation. Policymakers resorted to a media “leak” (à la the June 13 Nick Timiraos article which tipped the Fed’s 75bps lean at last month’s FOMC meeting) to prepare the market for the possibility of a larger move. Earlier this week, Bloomberg said the bank “may consider” raising rates by 50bps instead of the quarter-point move tipped at the June gathering and socialized in subsequent weeks.

“The Governing Council judged that it is appropriate to take a larger first step on its policy rate normalization path than signaled at its previous meeting,” the July statement said. “This decision is based on the Governing Council’s updated assessment of inflation risks [and] will support the return of inflation to the Governing Council’s medium-term target by strengthening the anchoring of inflation expectations and by ensuring that demand conditions adjust to deliver its inflation target in the medium term.” The statement conveyed the ECB’s intention to hike further at upcoming meetings.

Inflation in the eurozone rose to a new record of 8.6% last month and the juxtaposition with consumer confidence (figure below) tells you a lot about the ECB’s extraordinarily vexing dilemma.

The European Commission’s monthly confidence gauge fell to a record low in July, when recession fears, war jitters and, relatedly, soaring prices for food and energy, weighed heavily on consumer psychology.

Plainly, Christine Lagarde risks exacerbating the region’s burgeoning economic downturn with rate hikes, but she has little choice. Headline inflation is more than quadruple the bank’s target. Years of tedious forward guidance aimed at anchoring volatility and tamping down spreads became a prison for policymakers. The ECB was constrained in their capacity to bring forward hikes by the necessity of ending net asset purchases in two QE programs first. That doomed Lagarde to outlier status among developed market central bankers in the race to get rates to neutral.

July’s policy statement was an attempt to break out of the forward guidance prison. Today’s front-loading “allows the Governing Council to make a transition to a meeting-by-meeting approach to interest rate decisions,” the bank said.

Between foot-dragging dictated by the sequencing set out in the bank’s forward guidance and the long shadow cast by the threat of curbs to Russian gas flows, the euro slid to a two-decade low, reaching parity with the dollar earlier this month. Thursday’s hike, no matter the size, was destined to go down as a decision taken too late, and with little conviction relative to the size of Europe’s inflation problem (figure below).

The ECB is, in essence, an emerging market central bank — Lagarde is compelled to hike rates into the teeth of a recession to avert capital flight amid an exogenous shock that exposed an existential economic vulnerability.

Although the Kremlin resumed flows through the Nord Stream on Thursday following pipeline maintenance, thus sparing Germany an overnight calamity, flows are nevertheless crimped and there’s every reason to believe Vladimir Putin will continue to implicitly threaten a total shutoff in retaliation for sanctions and weapons shipments to Ukraine.

Meanwhile, political turmoil in Italy raises the odds that the ECB will actually have to use a tool (the anti-fragmentation mechanism) that many market participants doubt is battle-ready. It was cobbled together hurriedly following a mini-tantrum which forced officials to convene an emergency meeting just four business days after last month’s policy gathering.

Details on the Transmission Protection Instrument were initially sparse. “TPI will be an addition to the Governing Council’s toolkit and 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 statement said, adding that “the scale of TPI purchases depends on the severity of the risks facing policy transmission.” Additional parameters were unveiled in a separate communique. Flexible deployment of reinvested principal payments from purchases made under the bank’s pandemic QE program will remain “the first line of defense,” the bank said. The larger hike increment was the price hawks exacted from doves for TPI.

If markets doubt the ECB’s preparedness, they’ll test the bank’s resolve. The collapse of Mario Draghi’s government in Italy, and the protracted period of political turmoil it portends, is as good an excuse as any in that regard.

The irony would be delicious if livelihoods (and actual lives) weren’t at stake. A decade (almost to the day) after Draghi saved the euro in the face of acute fragmentation risk with his famous “Whatever it takes” speech, his successor is staring down the same risk, this time precipitated by the demise of a coalition government headed by Draghi.

Unfortunately for Lagarde, inflation realities mean her efforts will be hamstrung by the necessity of hiking rates, which could easily run at cross purposes with attempts to cap spreads. If only her predecessor had raised rates when he had the chance, she might be in a better position. But, spilt milk under the bridge.