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The ECB has an opportunity to build a sound banking sector

The unprecedented spree of merger proposals roiling Italian banks lately raises three questions: why is it happening, and why now? Are those proposals good or bad? And what should authorities and investors – the first being asked to approve them, the second to finance them – do?

The future of the Italian banking sector, until recently among the continent’s weakest, may well depend on those questions being given the right answers.

Like Tolstoy’s unhappy families, those proposals all differ from one another. First, Unicredit’s approach to Commerzbank is the boldest: it would create a unique and innovative cross-border bridge between Italy’s and Germany’s traditionally conservative banking environments. Unicredit is two times larger by market capitalisation and more profitable. It already owns a mortgage unit in Germany and close to 10% of Commerzbank itself. European Central Bank supervision must authorise the Italian lender rise to 28%, which would open up various possible combinations. The main obstacle to the deal is the fierce opposition of the German political establishment. Whether this opposition will survive the election outcome, which is expected to lead to a new Christian Democratic Union/Christian Social Union-led coalition, remains to be seen.

Second, Unicredit’s bid for Banco BPM, a mid-size retailer rooted in Lombardy, would strengten Unicredit’s domestic footprint in a cash-rich region. Here, too, the acquirer is larger and stronger, by cost and price-to-book. A concern is whether Unicredit, even with its considerable experience and managerial strength, would be able to digest two mergers at once.

The third proposal – MPS’s share exchange with Mediobanca’s shareholders – was the biggest surprise. The two entities are complete strangers geographically and by business model, let alone corporate culture. The former is smaller and weaker by most metrics, in spite of repeated capital injections by the Italian Treasury, which still owns a 11% stake in it. Many believe Italian politics to be active behind the scenes, as part of a strategy that would bring MPS’s large and government-friendly shareholders close to controlling the giant insurer and asset manager Generali, in which Mediobanca owns a large stake.

The latest proposal is the share exchange offer by BPER, a retailer based in the central-northern town of Modena, to Banca Popolare di Sondrio. The two partly overlap by business type but not geographically. Here the acquirer falls short of the acquired by price-to-book, but not by size.

Why Italy?

Why do these diverse cases all involve Italian entities? Nothing of the sort is happening anywhere else. The reason is that the Italian banking sector benefitted more than others from the clean-up engineered by the ECB after 2013, and more recently from the increase in interest rates and lending margins. Stronger banks are more inclined to expand. What we see is a welcome sign of strength and vitality in a country often considered the epicentre of Europe’s financial risks.

That said, the variety of situations calls for a roadmap, or at least a compass, helping authorities and investors to discriminate. The simplest possible criterion – balance sheet size – cannot be the only one, although it does matter. Size is a measure, crude as it may be, of the resources and structures the acquiring bank can deploy to manage the acquisition without being disrupted by it.

But size can even be a handicap if those resources and structure are used inefficiently. No single criterion measures how a bank’s managerial and business styles affect its value; market assessment provides a good summary. If the acquirer’s price-to-book is high compared to that of the acquired, the former has an advantage from intangible components of its value. This may also bring a tax advantage by generating badwills.

A crucial consideration is how elements of strength may combine. If the banks overlap geographically, for example, savings in structures and personnel are possible. Functional duplications, such as banks providing similar services, can also lead to cost-saving simplifications.

A fourth criterion is increasingly important for regulators. As argued by former Italian Prime Minister Mario Draghi in his 2024 competitiveness report, a major weakness of continental Europe is the fragmentation and small size of its banks. European Union regulation does not allow cross-border banking groups to conduct business efficiently. The report mentions regulatory changes that would remedy that.

A long journey starts with one step: that’s why the decisions the ECB is about to make are important. Of the four proposed deals, Unicredit’s cross-border project is the only one that seems to possess all the characteristics of a good combination.

ECB supervision already made a historic contribution after the 2008 financial crisis by restoring the soundness of euro area banks. Now it has another opportunity: helping complete the banking union and build a banking sector of continental dimension. It should not miss it.

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Central bankers must answer fundamental questions over two decades of crisis

The monetary debate seems hijacked by a simple set of questions: when will central banks reduce interest rates? How fast and by how much? While the US Federal Reserve System seems inclined to wait, recent statements from the European Central Bank suggest a rate cut will be decided at the ECB council’s next monetary policy decision-making meeting on 6 June. Is there space for it? Little, at best.

Pressure is significant. Financial institutions may profit from declining interest rates and looser credit conditions. Their desires are often aligned with those of indebted European governments keen to lock in cheaper borrowing costs.

The ECB’s anti-inflation stance appears to be working. Inflation has been declining towards the goal of 2%, but is not yet conquered. If there is one lesson we have learned from the recent past: Don’t take the future for granted.

Discounting the recent negative surprise – the May outturn surpassed expectations, for both headline and core inflation – a minor move of a quarter percentage point may fit in, but not the sequence of cuts that many market practitioners have recently been expecting. After that cut, the next stance must be ‘wait and see’.

It would also be the first time in its quarter-century-long life that the ECB cuts the policy rates when inflation is both above target and rising in its last reading, according to both metrics. Anything wrong with that? No, provided communication explains that the cut is ‘expectations based’, not ‘data dependent’. And, of course, that expectations turn out to be right.

Beyond the immediate issue of interest rate cuts, many other pressing matters need to engage central bankers’ attention. They have had to navigate frequent upheavals in the past two decades: near-collapse of financial systems followed by recession, massive prolonged monetary expansion, a global pandemic, another recession,  the worst inflation shock in the preceding half-century and now, war in Europe and in the Middle East.

What is monetary policy for in a radically changing world?

This combination of crises, and the often disjointed fiscal and monetary policy responses, raise many fundamental questions. These focus on the impact on both price and financial stability of prolonged monetary expansion and sharp changes in direction of monetary policy. Only a few have been tackled in a serious way, let alone answered properly.

Learning from the past two decades, how should we articulate and quantify central bank targets? How can the policy-making community better identify different sources of shocks and react to them? What are the merits and risks of negative rates? Should ‘exit strategies’ become part and parcel of any unconventional or extreme monetary policy move? What is the right degree of interest rate gradualism and pre-commitment? Most fundamentally, what interest rate should central banks aim for on average over the cycle?

Fed and ECB on different paths since 2015

The recent experiences of the US and the euro area highlight noticeable differences. Inflation performance was strikingly similar in the years preceding the Covid-19 pandemic, yet monetary policies diverged sharply.

The Fed raised its target (federal funds) interest rate decisively between 2015 and 2019, while the ECB brought its rate into negative territory and kept it there. When the pandemic hit, the Fed had more room for manoeuvre on interest rates. The ECB’s response relied mainly on quantitative easing through a new facility, the pandemic emergency purchase programme.

Both the Fed and the ECB delayed their response to the rise in inflation by about a year – the former between March 2021 and March 2022, the latter between August 2021 and July 2022.

Inflation started rising earlier in the US; in the euro area, it peaked later, at a higher level. In both cases, the delayed responses led to sudden and steep rate increases, but at quite different levels: the Fed from zero to 5.25%, the ECB from minus 0.5% to 4%. After all this action, the respective inflation rates, measured by the respective ‘headline’ indices are now roughly the same.

Need to rethink operational concepts and practices

The radically different and unpredictable global environment might have induced central bankers and other policy-makers to rethink operational concepts and practices. But this is at risk of not happening. The Fed and the ECB conducted monetary policy reviews in 2019-21, when most of the above shocks were still in the making or yet to come. Both of them seem largely obsolete today, or at least incomplete.

Judging by the review by Ben Bernanke for the Bank of England, largely limited to forecasting techniques and communication, there is little appetite for a wider angled view on these questions. Academic research takes time and tends to lag well behind events.

Simple-minded monetarist theories are largely discredited today, but it is impossible to look at the last 15 years without asking whether the prolonged phase of QE and the absence of proper exit strategies, caused or at least contributed to the rise of global inflation in the early 2020s.

The question extends to financial stability. In the US, the unprecedented sequence of hasty expansion and restriction in 2020-22, with ensuing massive shifts in bank balance sheets, was one of the main reasons for the spring 2023 banking turmoil.

Monetary policy and financial stability, traditionally separate within central banks with limited interaction and cross-checks between them, may be more related than we thought.

All these questions are fundamental to understanding and steering the global economy. Policy-makers need to show greater willingness to devise ways of coming up with some answers.

With the broader questions still unanswered, the economic ‘permacrisis’ – the expression used by Gordon Brown, Mohammed El Erian and Michael Spence in a recent book – is at risk of being wasted. In this policy-making vacuum, the right approach should be dictated by prudence. ‘If you don’t know what you are doing, do it gently’, as an old motto goes.

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Difficult road ahead for new Banca d’Italia governor

Italy has a new governor at the helm of its central bank. The event deserves more attention than it elicits. True, the Banca d’Italia has lost most of its powers to the European Central Bank in the last quarter-century. But as the country’s most respected economic technocracy, its persuasion and guidance can still play a key role at a juncture that may evolve into one of the most critical and dangerous in the nation’s recent history.

The appointment of Fabio Panetta ends the double six-year tenure of Ignazio Visco, a respected economist who unexpectedly found himself in the governor’s seat following the departure of Mario Draghi, who became ECB president in November 2011.

Visco’s mandate wasn’t easy. He presided over momentous events like the loss of banking supervision to Frankfurt, high-profile banking failures (partly attributed to earlier supervisory mistakes of the bank) and unprecedented pandemic and inflationary shocks, all handled in co-operation with eight different prime ministers of the most diverse political hues.

Perhaps because of those troubled circumstances, Visco’s governorship didn’t shine. The institution under his purview did not enjoy the migration of bank oversight to the ECB, occasionally expressing reservation about the latter’s proactive supervisory stance.

Farsightedly, the bank supported Draghi’s ‘whatever it takes’ moment in 2012 and his subsequent policies against deflation. But it spectacularly failed to see inflation coming in the early 2020s, taking ultra-dovish positions even after it was clear that price stability was in jeopardy according to all meaningful definitions.

Its defence of fiscal caution sounded feeble while the country’s debt-to-gross domestic product ratio was rising to 144% in 2022 from 134% in 2019, and again recently when the government announced significant upward revisions of public debt and deficit goals for this year and the next.

Those past challenges pale compared to what the future may hold. The country’s economic and financial prospects look increasingly testing. Headline inflation, after peaking at around 12% a year ago, fell sharply in October. But with core consumer price index growth still over 4%, it is too early to declare the battle won.

Public finance, the mother of all Italian problems, is in a worrisome state. The coalition, headed by Prime Minister Giorgia Meloni and including forces that have always been reluctant to endorse fiscal caution and Europe’s budget surveillance, has relaxed its fiscal targets. The debt-to-GDP ratio is likely to start heading up again, contrary to official projections. The spread of Italian 10-year bonds over the corresponding German paper hovers around 200 basis points. Unprecedentedly, the Italian state now pays investors over 50 basis points more than Greece does.

Another hurdle not to lose sight of is the Italian banks. The largest ones have improved markedly in the last decade, partly as a result of relentless supervisory pressure by the ECB. But there remain weak spots among the small and medium-sized ones. The combination of a stagnating economy and rising public debt may interact viciously with the weakest part of the banking sector, reigniting the ‘doom loop’ that nearly brought Italy down in 2011.

Panetta, the seasoned central banker that Meloni appointed to succeed Visco, has solid professional credentials and experience. A long-time Banca d’Italia insider, he was intimately involved in all past decisions, both good and dubious. But now he has the opportunity to make a fresh start. How he handles this will define his tenure.

The bank needs to build new and solid alliances in the ECB decision-making governing council, along a careful but unambiguously anti-inflationary monetary line. It needs to convince the government to put debt consolidation above all other priorities, putting aside overly ambitious tax reduction plans.

Italy must accept a quantum of binding European surveillance on its public debt as part of the negotiation on the reform of the Stability and Growth Pact. It must ratify as a matter of urgency the reform of the European Stability Mechanism, which gives financial assistance to indebted states, a reform so far blocked by Italy alone. Last and not least, the central bank should work to strengthen the credit sector further, in close co-operation with European authorities.

All these steps are clearly in Italy’s interest. Undertaken convincingly and in combination, they can ward off the clouds that gather on the economic horizon. The new Banca d’Italia governor can exercise a key influence in promoting that agenda. Let’s hope he will.

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A new digital currency would have to be ‘very innovative’ to compete

The European Central Bank is preparing for a possible digital euro. This would be a liability of the bank, like paper currency and deposits. However, with digital currencies in high supply in a saturated market and traditional payment methods remaining popular, the ECB needs to assess if launching the digital euro is worth the effort.

Deposits at the ECB have grown enormously as a result of quantitative easing and now stand at €4tn. In the 21 years of their existence, euro banknotes have increased seven times in value – up to €1.6tn – amounting to a compounded annual increase of about 10%. The corresponding figure for the dollar is 6.5%, while sterling is 5.2% and the Swiss franc is 4.4%.

Some argue that the popularity of cash is due to growing illegal activities, but this is unlikely to explain the phenomenon. Until now, the increase of the euro in circulation has been very steady; indicators of criminal activity do not have such a smooth profile. And the increase in euro coins shows more or less the same pattern. Criminals and tax evaders are unlikely to make extensive use of coins.

It seems that people actually like holding euro banknotes, despite the fact that, for many retail purposes, they are being replaced by more convenient digital means – online platforms, payment cards and smartphone applications. This preference has implications for the digital euro.

Accounts for the digital euro will be offered mainly by banks and all front-end functions will be carried out by them. Importantly, the digital euro will look very much like a bank deposit and banks will be responsible for onboarding and offboarding, know your customer and anti-money laundering checks, as well as providing all services normally associated with deposits – online banking, payment cards and apps. From a user perspective, there will be no difference between making a digital euro deposit or making a deposit at a bank as they will include the same processes, require the same information and provide the same forms to fill out.

The introduction of a digital euro would most likely result in a move away from bank deposits, rather than from paper currency. Banknotes have unique characteristics – simplicity, absolute privacy and tangibility – that are highly valued, which the digital euro will never have. However, substitution between digital euros and deposits entails complications and concerns for the conduct of monetary policy and for financial stability.

The digital euro would magnify the risk of bank runs because it would offer a risk-free online alternative to bank deposits. In the euro area, this risk is compounded by the incompleteness of the banking union, specifically the lack of area-wide deposit insurance.

However, the main unknown of the project is the reception by the market – already saturated with digital payment systems. To compete with powerful incumbents like Apple Pay or Google Pay, or even smaller but efficient service providers like Revolut, the new entrant would have to be very innovative. This is not likely to be the case for the digital euro. Failure to market it successfully would have negative reputational and cost implications for the ECB.

The private digital payments sector has been quite efficient over the last 20 years. It is hard to identify market failures that justify public intervention. The arguments in favour of a digital euro today are not strong enough to justify the launch of the currency. However, this decision will not made for several years at least, which means there is plenty of room for unknowns in the meantime.

We could witness, for example, a collapse in the use of banknotes, which current digital payment providers and their infrastructures cannot handle with the available technologies. Or we could experience financial instability, requiring the ECB to step in to preserve the functionality of the payments system. Or there could be strategic security conditions requiring more state-controlled monetary and payment infrastructures.

Fortunately, these are very unlikely scenarios, but not impossible ones, which may call for central banks to step in, perhaps within a short time. The best advice one can give to the ECB, and to other central banks, is: continue to prepare, otherwise, wait and see.

This article is based on a keynote address given at OMFIF’s Digital Monetary Institute symposium in London on 9 May 2023. Read the full speech here.

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It’s time to address the monetary policy elephant in the room

Taken by surprise by the resurgence of inflation, the European Central Bank started raising rates last summer and is still in the process of doing so. At her press conference on 16 March, President Christine Lagarde started her remarks with: ‘Inflation is projected to remain too high for too long.’ She then announced a 50 basis point increase in interest rates, the seventh in a row.

This firm stance, after a week of tremors in the global banking sector, was supported by an overwhelming majority of governing council members; only ‘three or four’, she said (out of 26), did not support her proposal. This was a remarkable demonstration of consensus and resolve by a very large committee.

Out of the spotlight, meanwhile, there is a huge elephant in the monetary policy room: the central bank’s balance sheet. Years of massive expansion have deposited a staggering €4tn of idle liquidity in the pockets of euro area banks. Until that stash of cash goes away, the ECB can only raise rates by subsidising the deposits it receives from banks. The remuneration on its deposit facility was raised from minus 0.5% last July to 3%, on a riskless basis. It will probably go beyond that. This is a hefty subsidy to bank shareholders: except for them, nobody today can access a risk-free rate of 3% in the open market.

This is a dangerous course. The assets the central bank holds against these deposits yield returns far below the funding cost. Calculations by Daniel Gros, a senior fellow of the Centre for European Policy Studies, show that this is enough to wreck the accounts of the ECB and its constituent national central banks in the years ahead. Bundesbank President Joachim Nagel must have felt some embarrassment recently as he announced to the German public that the losses of the German central bank last year are not covered by provisions. This is an accounting euphemism to say that the central bank may need financial support from the government, and indirectly from the national taxpayer.

Economic textbooks say that central banks cannot go bankrupt, but this is another euphemism. It is easy to think of situations where the central bank and the money it issues – the euro in this case – loses support and reputation among public opinions and political circles, some of which in Europe edge towards populism. When this happens, the loss of central bank independence is just around the corner.

The only way for the ECB to stay clear of danger is to keep its deposit facility rate low. But this is compatible with the intended monetary policy course only if the bank liquidity and the central bank’s outright portfolio of securities – two amounts which are roughly equivalent – are reduced in parallel, and fast. The ECB has started scaling down its securities holdings at a pace of €15bn a month on a net basis. This is not sufficient. Other things being equal, it would take some 27 years to reabsorb all the liquidity that is around through this channel alone. The ECB cannot afford to wait that long.

One way to accelerate the process is to re-activate a long-term liquidity-management instrument introduced by the ECB in 2014, the so-called ‘targeted long-term financing operation’, but in reverse. The new reverse long-term operation would auction out rights to swap central bank deposits for long-term securities on a long-term basis according to the maturity of the bonds. Auction participation would be voluntary but incentivised. Banks deciding not to swap out their central bank deposits would be penalised by a lower deposit rate. Swap rights could be calibrated by taking into account the balance of each bank at the deposit facility.

Calculations suggest that an auction mechanism so designed would induce profit-maximising banks to swap away large amounts of their deposits in exchange for temporary (but long-term) government bond holdings.

Regardless of the specific mechanism chosen, one thing is clear: a coherent package of measures and incentives lowering the deposit rate and reducing bank liquidity alongside the central bank’s portfolio is the only way the ECB can maintain monetary control and salvage, together with its own accounts, its operational flexibility and independence. The issue is urgent. Most national central banks of the euro area will soon present their accounts for 2022. At that time, the monetary policy elephant and its impact on European taxpayers will be apparent. The ECB would be better off having answers when this happens.

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The central bank must maintain control of its balance sheet

The European Central Bank’s policy orientation – a rapid series of small interest rate increases to rein in inflation – is now clear. ECB President Christine Lagarde said in the December press conference that the situation ‘predicates another 50 basis point rate hike at our next meeting, and possibly at the one after that, and possibly thereafter’. She reiterated this warning on 19 January. Klaas Knot, governor of De Nederlandsche Bank and an influential member of the ECB governing council, stated that the interest rate rise is now ‘at the beginning of the second half’, following an increase of 2.5 percentage points from July to December 2022.

A separate and scarcely debated issue is how this will be done. On the surface, this seems like a sideshow, but in fact it hides trouble in the making. The consequences may later hit back at the central bank where it hurts most: its independence.

In the last 15 years, the ECB, like other central banks, changed its operating framework. Before 2008, it was usual practice to leave the banking system short of liquidity and refinance it through frequent repurchase operations. After the financial crisis, the large-scale asset purchases (quantitative easing) produced a chronic excess of bank liquidity.

With Covid-19, QE restarted at full speed: liquidity, virtually zero in pre-crisis times, is now as high as €4tn, some 30% of the euro area’s gross domestic product. This is a striking example of what the UK House of Lords’ Economic Affairs Committee in 2021 called the ‘ratchet-up effect’: QE rises with every adverse shock but is not withdrawn subsequently. The committee’s report also notes that the beneficial effects of QE beyond the short term are more doubtful than central banks have assumed.

There are two approaches to dealing with the accumulated monetary overhang once interest rates start rising. One is to put QE in reverse, selling the bonds previously acquired or not renewing them at maturity until the overhang is reabsorbed. The other is to leave this ample liquidity within the banking system and lift market rates by raising the interest on the ECB’s deposit facility.

Both approaches are effective in steering rates, but with the second the central bank retains a large portfolio of Treasury bonds in its balance sheet on a permanent basis. QE, once thought to be an ‘unconventional’ measure to face emergencies, becomes the norm in the sense that its consequences are permanent.

Early signs suggest that the ECB leans towards the second avenue. Since last July, the deposit rate has been lifted in line with other rates. A moderate scale-down of the bond portfolio (€15bn per month) is expected to start in March, but a high deposit rate (now 2% and rising), which is riskless, discourages banks from acquiring Treasury bonds, all of which are to various extents risky.

In 2019, the US Federal Reserve announced its intention to continue to operate with an ample liquidity framework. The ECB may be tempted to follow its example. One argument given for that decision was that de-linking liquidity from interest rates helps reduce financial stability risks. As a general argument, however, this is unconvincing. A central bank should always be ready to expand liquidity in a crisis and have the instruments and powers to do so, but nothing requires that large liquidity volumes be maintained at all times.

In the case of the ECB the balance of the argument weighs on the opposite side for three reasons.

First, in the euro area institutional setting, the ECB acts largely alone, without support from a centralised budget or other policy instruments at the federal level. This encourages among political and public opinion circles the misleading impression that the central bank can and should deal with any problem and shock. If the ECB convinces itself and others that monetary policy can be conducted equally well with any level of liquidity and public securities holdings, the pressure to finance governments at any plausible occasion and without an exit strategy may become irresistible. At that point independence is lost and with it a vital monetary counterbalance to the fiscal power of the nation states.

The second difference is that the euro faces a unique risk linked to the fragility of some of its members’ fiscal side – fragmentation. Former ECB President Mario Draghi’s commitment to do ‘whatever it takes’ to salvage the currency has made this an implicit responsibility of the ECB. In 2012 that bet paid out beautifully – the euro was salvaged at no immediate expense – but that outcome is unlikely to be repeated. Any potential future fragmentation episodes risk bringing the central bank into a commitment trap, requiring an ever-growing monetisation of government deficits.

Finally, long-run evidence indicates that potential growth in the euro area is less dynamic than in the US. Reform and investment programmes launched by the European Union may change that but, until that happens, calls on the central bank to stimulate demand – also through QE operations in spite of the doubts about their effectiveness – are likely to persist.

The ECB will be able to fulfill its responsibilities in the complex environment it finds itself in only if it maintains control over its balance sheet. This now requires combining the planned interest rate tightening cycle with a marked scale-down of its public securities holdings, de-linking the deposit rate from market rates as soon as feasible and returning to a ‘limited liquidity’ operating framework. After clarifying recently its interest rate intentions, this is the next front where the ECB should demonstrate its resolve.

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Euro area anti-fragmentation scheme requires clarity in four key areas

The European Central Bank’s transmission protection instrument to limit divergences in borrowing costs allows for sterilised purchases of sovereign paper to prevent cross-country interest rate spreads from reaching unspecified unwarranted levels. The TPI, announced on 21 July, does not aim at influencing overall euro area monetary conditions, but at preserving the effectiveness of monetary policy in individual countries: protecting the ‘monetary policy transmission mechanism’ (MTM).

The TPI was launched together with a 0.5 percentage point interest rate increase, larger than expected. That’s no coincidence: the TPI aims to allow higher interest rates while soothing concerns over turbulence in higher-risk sovereign markets. The necessary compromises over the TPI, and the haste in assembling them, have left important details unspecified. These are now under discussion by Eurosystem committees and national central banks. The ECB needs to formulate a TPI ‘user manual’ to clear up any vagueness which could complicate its activation.

The new programme bears some resemblance to the outright monetary transactions, launched in 2012 when Mario Draghi was ECB president. Although it was never used, many observers credit the OMT for having saved the euro area from collapse. Both programmes aim at limiting sovereign interest spreads and have no pre-set maximum for bond purchases. Both programmes were justified, with different nuances, by the need to preserve the functioning of monetary policy.

The main technical difference is that the OMT foresees bond purchases in the short-term (one to three years) whereas the TPI could stretch up to 10-year residual maturity. The main political difference is that OMT activation must be preceded by the respective country reaching an agreement with the European Stability Mechanism, in the form of a credit line, either ‘precautionary’ or fully-fledged with an accompanying adjustment programme. By contrast, the TPI relies on an autonomous judgement by the ECB, based also on elements provided by the Commission, the ESM and the International Monetary Fund.

For the TPI to work, a user manual is essential. We propose these main ingredients.

First, like the OMT, TPI intervention should focus on the short side of the interest rate structure, which matters most for monetary policy transmission. In 2012-22, with interest rates stuck close to the zero lower bound, monetary policy departed from the normal mechanism of working via a chain of interest rate impulses in different market segments. With net bond purchases ended and interest rates headed above zero, normal MTM, centred on interest rates passing through to bank lending conditions, will now be restored. The TPI should be used sparingly, mitigating risks of turbulence when there is clear evidence that short-term spreads are excessive, risking a lopsided MTM. In the same context, it will be important to keep the conditions of banks under scrutiny. With its quarterly bank lending survey and much supervisory information at its disposal, the ECB has all the information it needs for effective monitoring.

Second, the relationship between the TPI and OMT should be clarified. Christine Lagarde, ECB president, has underlined that the OMT was meant to deal with ‘redenomination risk,’ (the threat that one or several countries could leave the monetary union or that the system as a whole could collapse). The TPI should deal with the risk of ‘unwarranted’ risk spreads damaging MTM. However, Lagarde has been silent on the relationship between the TPI and OMT. We think the TPI should be used first. Countries with sustainable economic conditions wishing to pre-empt risks should be encouraged to obtain an official ‘certification’ of this fact from the ESM, applying for a precautionary line which, under ECB guidelines, can open the way to unlimited intervention via the OMT. Countries with deeper economic and financial imbalances should approach the ESM for a credit line, based on an adjustment programme which, if adhered to, would also open the way to OMT. The distinction between the two ESM facilities should be clear, at least in principle. While the PCL aims at protecting the country from unwarranted market speculation (unwarranted because the country’s economy and finances are sustainable), an ESM-sponsored adjustment programme aims at correcting fundamental imbalances.

Third, an important point, not yet specified, is whether the risk (and returns) of TPI purchases will be borne individually by the NCBs, hence indirectly by the respective sovereigns, or will be shared according to the ECB capital key. This is not a technical detail but an important design feature, with large economic consequences. The burden-sharing of central bank operations affects national sovereign risk, hence potentially the cross-country asymmetry of MTM. The logical conclusion is that, if the TPI is focused on protecting MTM, and related bond purchases are confined mainly to the short-term segment, then the costs and risks of such purchases should be shared. This was intended to be the case for the OMT and is usual practice for all monetary policy-related operations.

Fourth, the ECB has indicated that MTM will be protected from Covid-19 risks first and foremost by a ‘flexible’ pandemic emergency purchase programme-related reinvestment policy. Lagarde has called this ‘the first line of defence’. In June-July this year, PEPP reinvestments have been 100% in securities from countries facing higher rates, particularly from Italy, revealing that the ECB has been selectively intervening to close these countries’ spreads. The ECB has not explained the reasoning behind this extreme concentration of ‘flexible’ reinvestments, including, crucially, whether this is linked to the pandemic. Lagarde has stated that the difference between the TPI and unbalanced PEPP reinvestments is that the latter should be motivated by the aim of mitigating pandemic effects. The ECB should clarify that this condition still holds. The combination of ‘flexible’ PEPP reinvestment and the TPI should not go as far as significantly reducing over time the free float of high-yielding securities, which would dry up market liquidity. The ECB must avoid being caught in a ‘fiscal trap’ where it needs to finance a sovereign because of a lack of a proper market for its securities.

Today, there is a lower risk of euro-wide crisis than in 2010-12. The euro area economy has improved significantly since 2012. Intra-area external imbalances have largely disappeared. Market risks are now essentially concentrated on one country: Italy. Other countries previously under financial stress – for example, Spain and Portugal – now are subject to much smaller interest spreads. Even Italy’s conditions have improved significantly in some respects (for example, bank solvency and non-performing credit ratios), though the public debt to gross domestic product ratio is higher and political risks may resurface after the fall of Mario Draghi’s government.

One the other hand, the TPI must work in a radically different economic environment. Inflation is way above target. Monetary policy must become increasingly restrictive to fulfil the ECB’s price stability mandate. The TPI will function satisfactorily only if the rules of engagement are clear: its user manual should be agreed as soon as possible, and made public, in time for the next governing council meeting on 8 September.

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A way of solving the ECB’s fragmentation problem

There is a solid and relatively trouble-free way to help Italy and overcome the European Central Bank’s problem of ‘fragmentation’, which is becoming a major challenge for financial markets. Italy should turn to the European Stability Mechanism, the European Union’s financial support scheme. It should apply for a credit line under the ESM’s precautionary facility, designed for countries whose economic and financial situation is fundamentally sound.

Italy fulfils all the conditions to access that facility. The ESM would need to certify that fact. A credit line would be open but Italy would not draw on it. This would open the door for the ECB to purchase Italian bonds with an instrument which already exists, not a new and imponderable one. Italy (with Germany) has not yet ratified the new ESM treaty, but this is not an obstacle: the precautionary instrument can be activated under the old treaty as well as under the new one.

If Italy applied for such a precautionary line, this would allow the ECB to use its most powerful anti-fragmentation tool – the outright monetary transactions mechanism, launched by Mario Draghi as ECB president in 2012. OMT, together with the three famous words (‘whatever it takes’) worked wonders without ever being used.

Under the OMT umbrella, an ECB intervention programme designed to control sovereign spreads would be well grounded, legally and functionally. It would provide the ECB, and Italy itself, with valuable insurance to weather the potentially troubled waters of coming months. At the moment, buying such insurance is relatively cheap. It may become more expensive.

Using the OMT in this way would avoid the problem of Italy applying for a fully-fledged ESM adjustment programme. This would be unpalatable politically as Italy approaches general elections, with a large component of eurosceptics in the political spectrum. In addition, an adjustment programme for Italy is unwarranted. The country is dealing satisfactorily with emergencies emanating from the pandemic and energy crisis. It is fulfilling the conditions of accountability and solid use of funds attached to Europe’s Next Generation EU programme. And in a number of fundamental areas, Italy’s economy has performed better than expected over the past 18 months.

Some of the difficulties the ECB now faces are self-inflicted. By delaying its response to inflation, the central bank is now forced to act faster, which can surprise and unsettle markets. This has resulted in the past few weeks of volatility in Italy’s yield spreads against other government bonds such as Germany’s. Moreover, the ECB’s insistence on stopping asset purchases before raising rates removed from its toolkit a precious shock-absorber to smooth the market impact of the upturn in the monetary cycle.

Just six days after pre-announcing a sharp rise in interest rates at the last regular policy meeting on 9 June, Christine Lagarde, ECB president, called an extraordinary meeting. She confirmed earlier indications that the ECB will deliver soon a new instrument against fragmentation – re-baptised in Italy as the ‘anti-spread shield’. Market expectations now focus on the next meeting, on 21 July.

Whatever is announced then needs to be credible and overwhelming. Markets would not take lightly another disappointment or postponement. It would become a very hot summer. Yet designing an effective ‘shield’ is not easy. With inflation above 8%, the response cannot be more monetary easing. Any purchase operations targeted on specific bonds would need to be ‘sterilised’, i.e. compensated by matching sales of other bonds to keep intact the desired overall monetary stance. It is noticeable that, unlike in the debt crisis of 2011-12, market pressure for now is concentrated on one country. Spain’s and Portugal’s spreads are about half of Italy’s.

At first glance, the solution is simple. It would require purchases of Italian bonds and sterilisation through selling low-spread sovereign bonds. Of Italy’s €2.75tn sovereign debt, €780bn is held by non-residents, a component which has been volatile in the past. The rest is with the Banca d’Italia and other Italian resident holders (largely banks). By coincidence, that amount matches almost perfectly the combined Eurosystem holdings of bonds of countries with triple a ratings: Germany, the Netherlands and Luxembourg. Theoretically, the ECB could enact a ‘twist’ between the two classes of bonds, or at least announce a willingness to do so, in the hope that mere announcement (as was the case for the OMT) would calm markets.

Unfortunately, whatever its technical merits, such a programme would be inconceivable for many reasons. It would be hard to justify on pure monetary policy grounds. Lagarde herself said, in March 2020 at the start of the Covid-19 outbreak, that the ECB was not tasked with closing spreads, though she later tempered that statement.

More complicated from a technical viewpoint is that such an operation would require the ECB to have, at least internally, a trigger level for setting off intervention. What would that be? Ignazio Visco, the Banca d’Italia governor, has indicated that a German-Italian spread above 2 percentage points for 10-year bonds is unjustified. Limiting the spread in this way may require large sale and purchase operations, with two undesirable consequences. First, it would structurally weaken the market for Italian paper – foreign holders are comparatively active and help provide much-needed liquidity. Second, the balance sheets of the central banks might suffer. A 2016 ruling of the German constitutional court warned against a negative impact on the Bundesbank of ECB’s operations. The risk of legal challenge is always just around the corner, severely lowering the plan’s credibility.

For all these reasons, the ECB council should not try to devise a thoroughly new programme, but make use of an instrument already in its toolkit. The ESM’s precautionary facility represents the right way forward – protecting both Italy and the future functioning of monetary union.

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Sequencing approach needs to be abandoned

Renewed interest in monetary policy discussions coincides with new problems and risks facing central banks. How to deal with the pandemic – particularly the exit from it? Can the rise in inflation be controlled? Should wartime risks be factored in? Undecided on how to move, central bankers have been dragged into controversies which risk denting their leadership and prestige.

And yet, these problems should not be too difficult to resolve. At least not for central banks with clear statutory goals – all central banks have them now – and sufficient resolve.

The situation is easiest in the US. Its economy was hit by two shocks: one with mixed supply and demand effects, the pandemic; the other with pure demand effects, Biden’s fiscal expansion. The obvious response was a monetary restriction. After some delays in recognising this reality, Chairman Jay Powell’s Federal Reserve has put itself clearly on that path.

The European Central Banks’s situation is trickier. To start with, the euro area had no fiscal shock: Next Generation EU, Europe’s response to the Covid-19 crisis, has still to produce its effects. The increase in inflation during the pandemic originated solely from supply constraints. Assuming these were temporary, after making a big initial move in 2020 with its pandemic emergency purchase programme, the ECB put itself in a wait-and-see mode.

Unfortunately, after this sensible start, the ECB committed two errors which now present their bill.

The first was to enshrine this fundamentally tactical posture into a ‘strategy’ which prescribed prolonging wait-and-see until clear and present inflation signs were seen. This was wrong for two reasons. First, the monetary stance was already out of balance, with negative rates unjustified in the absence of any deflationary risks. Second, the particular uncertainties connected with the developments of the pandemic required maintaining flexibility to react to all unforeseen events, including an unexpectedly rapid exit. A wait-and-see approach written in stone made this more difficult.

The golden opportunity to fix the situation came in late 2021, with the euro area  growing more strongly than expected and the first signs of broad-based price rises appearing. At that point, more than ever, negative rates were out of place and a correction was needed. That’s when the second and related error set in. Prolonging wait-and-see, this window of opportunity was missed.

The ECB’s real problem is that loosening the expansionary stance risks reigniting fragmentation of the euro area. The ‘monster’ which took away the policy-makers’ sleep during the 2010-12 crisis is raising its head again, with the Italian sovereign spread now growing towards 200 basis points – the level of early 2011. The existential risk for the euro that fragmentation implies must be faced squarely.

As the ECB raises it policy rate from a negative level as a matter of urgency, it should retain flexibility and constructive ambiguity in its securities market purchases. This instrument has been demonstrated to work well against fragmentation. Purchases do not need to happen to be effective; the mere possibility that they could creates the type of two-way risk which makes bond traders cautious. The traditional sequencing approach which requires the ECB to stop purchasing bonds before raising rates needs to be abandoned.

As Bundesbank President Joachim Nagel said a few days ago, fragmentation is a constraint but it should not overwhelm the whole of the ECB’s mandate. It is a technical problem – because it affects the impact of monetary policy – with broader political ramifications. The central bank, with its unrivalled market intervention capacity, has considerable power to deal with it. As its 24th birthday nears, with its experience and reputation well-established, it is time for the ECB to take this problem more in hand.

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