D.he European Central Bank (ECB) lived up to its reputation as a fire brigade in the new year. Italy was shaken by a government crisis, but hardly anything was felt on the financial markets. The lockdowns are being extended all over Europe because of the rampant pandemic. But the stock exchanges mark new records almost every day.
The reason for the remarkable serenity of investors has a lot to do with the monetary authorities. Obviously they have developed into a kind of fully comprehensive insurance. As the news agency Bloomberg reports, the central bank is currently intervening in the markets with the firm goal of limiting the yield differentials between the strongest and weakest economies in the euro area.
This would have reported “people familiar with the matter”. The central bank has specific ideas about which yield differences, i.e. so-called spreads, are appropriate. The ECB declined to comment.
In the financial markets there has long been the impression that the central bank is secretly operating a kind of interest rate curve control. This is not only supported by the development of Italian government bond yields in the current government crisis, but also by the tailoring of the pandemic purchase program PEPP, which gives the ECB a certain degree of flexibility in the selection of bonds to buy.
The new market strategy poses a major problem. Because if the monetary authorities switch off the centrifugal forces in the euro zone in this way, the euro will become more attractive for investors. This is exactly what can currently be observed in the currency markets. The common currency rose above the $ 1.23 mark at the beginning of the week and is now higher than it has been since 2018.
Against the dollar, the common currency has gained around nine percent compared to the previous year. And the euro is also currently strong when it comes to the currencies of other important trading partners.
But it is precisely this strength in the external value of the euro that counteracts the rest of the monetary policy of the central bank, which is still designed to stimulate growth and inflation in the euro area and to cushion the economic consequences of the pandemic. At the meeting on Thursday, ECB boss Christine Lagarde should therefore try to verbally slow down or even break the rise in the euro.
Inflation target will probably not be achieved
However, most experts do not expect any monetary policy changes. After all, the monetary authorities had only announced numerous measures at their most recent meeting in December. For example, the ECB had increased the so-called pandemic purchase program PEPP by 500 billion euros to a total of 1850 billion and at the same time extended the duration of the program until March 2022.
However, the questions the journalists put to Lagarde will still be tough. The head of the ECB is likely to be asked about the progress made in reviewing the monetary policy direction. There is enough reason to make rapid progress with this, as a glance at the weak price development alone shows: In the past few months, the inflation rate in the euro area has fallen continuously.
According to market participants, the central bank will not achieve its medium-term goal of an annual inflation rate of two percent either this year or next. In connection with the restructuring of monetary policy, the possible new fully comprehensive strategy could then also be discussed.
There has recently been evidence of this, especially with a view to Italy. It was recently noticed there that the bond markets had hardly reacted to the political turmoil in Rome. The risk premiums of ten-year Italian government bonds over Bunds rose by just 0.15 percentage points to 1.2 percentage points. In previous crises, market players had reacted much more allergically.
The interest rate premiums often soared by 0.5 to one percentage point. Government bond yields are key to fighting the pandemic crisis. Not only do they affect all other borrowing costs. Securing sustainable national debt has become a critical part of monetary policy as companies and employees rely on massive, debt-financed fiscal policy support.
“Bond volatility is at record lows,” said Tanvir Sandhu, chief strategist for global derivatives at Bloomberg Intelligence.
That goes down well with stock investors. The German share index Dax got off to a good start in the new year despite the seemingly never-ending lockdown and is trading close to historical highs.
Questions about unity in the Governing Council
But the fully comprehensive strategy is not without its risks. Not only does it go hand in hand with a rising euro, but also legally the ECB is moving in critical territory. “There are a number of problems with the choice of such a strategy or the inclusion in the ECB instruments,” said Katharina Utermöhl, economist at Allianz, the financial service Bloomberg. “This could give the impression that the ECB is actually doing monetary public finance.”
The measure also carries wider risks, such as encouraging careless fiscal policies as governments are partially freed from market discipline.
Historically, such a strategy has usually not had a happy ending: The Fed and the US Treasury Department, for example, agreed to cap refinancing costs in 1942 to help the country participate in World War II. Five years later, inflation was in double digits – and the central bank was forced to begin pulling back.
There is currently no sign of an overshooting of inflation and hardly any experts are expecting that. But it cannot be completely ruled out with a view to the future. The money supply has recently increased by more than ten percent. As a rule, such growth in the money supply was followed by an increase in inflation with a certain time lag.
There are also likely to be questions about unity in the Governing Council. The minutes of the most recent meeting in December revealed a certain amount of dissent. Accordingly, the council has rejected Chief Economist Philip Lane’s request to make the loans to banks more generous.
The volume of the PEPP crisis program is therefore not as high as originally announced. That, in turn, could be problematic for a central bank that is obviously committed to fully comprehensive coverage for the time being.