Next Thursday’s meeting of the ECB Governing Council is eagerly awaited. The rate hike decision has been pre-announced so the more important question is whether the new tool to address unwarranted sovereign spread widening will be unveiled. The rationale for such an instrument is well understood but its design and use raise several questions. One is easy to answer. To avoid a conflict with the monetary policy stance, bond purchases by the central bank would need to sterilized. The others are more challenging. Where is the threshold to call a spread widening ‘unwarranted’? Should the ECB be clear or ambiguous on this threshold and on its reaction when it would be reached? The final question concerns moral hazard and, hence, conditionality. When the ECB intervenes to address unwarranted spread widening, what are governments supposed to do in return in terms of fiscal policy?
Next Thursday’s meeting of the ECB Governing Council is eagerly awaited. The rate hike decision has been pre-announced so the focus will be on whether there is any finetuning of the guidance against the background of weaker survey data. The more important question however is whether the new tool to address unwarranted sovereign spread widening will be unveiled. The purpose of this Transmission Protection Mechanism[1] is to fight fragmentation risk inside the euro area that would result from a disconnect between government bond spreads and their fundamentals. Back in March, Christine Lagarde had insisted on the Governing Council’s readiness to “use a wide range of instruments to address fragmentation”, adding that, “if necessary, we can design and deploy new instruments to secure monetary policy transmission as we move along the path of policy normalization.”[2] A sense of urgency grew in June when sovereign spreads widened significantly, triggering an ad hoc meeting of the Governing Council on 15 June to discuss the market situation and leading to a statement that flexibility will be applied in reinvesting redemptions in the PEPP portfolio. Moreover, it had been decided “to mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council.”[3]
Addressing fragmentation risk is of major importance to avoid that monetary transmission would be adversely impacted by an excessive increase in bond yields in certain countries, giving rise to a negative feedback loop and destabilizing dynamics. However, the design and use of the – yet to be announced – tool require several questions to be answered. Firstly, when is a spread widening considered to be unwarranted? Answering this question is challenging because years of asset purchases as well as the Covid-19 pandemic and the ECB’s policy reaction (PEPP) have influenced interest rate differentials between euro area countries.