Raging inflation finally forces the ECB to abandon its reckless and absurd monetary policies and turn hawkish.
By Wolf Richter for WOLF STREET.
The ECB made two big announcements following its meeting today, July 21, 2022, and we’ll engrave this date into digital stone because it’s so important in the absurd NIRP fiasco:
One, the ECB finally exited its Negative Interest Rate Policy (NIRP) by hiking all its policy rates by 50 basis points, including its deposit rate, which was the negative rate, at -0.5%. This deposit is now 0.0%, and there are no more negative rates at the ECB.
And two, it showed off a new glue gun – the Transmission Protection Instrument or TPI – designed to prevent a sovereign debt crisis and keep the Eurozone together, even as the ECB hikes rates and reduces its balance sheet (quantitative tightening or QT) to fight raging inflation.
The rate hikes: RIP NIRP.
The ECB announced today that it would raise its three policy rates by 50 basis points.
These rate hikes were the first since 2011. And they were the biggest since June 2000 and November 1999, back when the ECB was still considered the guardian of a hard currency, rather than a reckless money printer, inflation arsonist, and NIRP-absurdist.
Effective July 27, the ECB will hike its:
- Deposit rate, from -0.5% currently, to 0.0%. RIP NIRP.
- Main refinancing rate, from 0.0% currently, to 0.5%
- Marginal lending rate, from 0.25% currently, to 0.75%
The ECB also put more and bigger rate hikes on the table, the next set of which will arrive at its meeting in September.
The ECB had committed in its prior communications that it would hike its policy rates by 25 basis points today. So today’s 50 basis point rate hikes were labeled a “surprise.”
But they weren’t all that much of a surprise since there has been lots of talk about bigger hikes by ECB Council members, including ECB Council member Robert Holzmann who said on July 9 that a 125-basis-point hike in September might be needed, if the inflation outlook doesn’t improve. They’re all talking now about big rate hikes. They want the world to take them seriously.
So that reckless and absurd dovishness at the ECB is now out the window, given the explosion of inflation the ECB has on its hands.
Grappling with the raging inflation fiasco.
In the 19-country Eurozone overall, CPI inflation hit 8.6% in June, heading for 10%, the way things stand. But it’s even more horrible in a number of the member states: in nine member states, CPI inflation is already 10% or more, maxing out at 22%.
CPI inflation started raging in March 2021, nearly a year before the war in Ukraine, blew past the ECB’s target in July 2021, and continued spiking, and hit 5.9% in February 2022.
These are scary-crazy inflation numbers, and the ECB has been the most reckless central bank among developed economies, given how long it sat on its idiotic NIRP and continued money printing, even as inflation was raging and spiking and spiraling out of control:
TPI, the fancy glue gun to keep the Eurozone together while hike rates and doing QT,
If this glue gun works as advertised, it would allow the ECB to follow through with rate hikes and QT, and keep doing them until the inflation spiral is under control, without getting distracted by a sovereign debt crisis and the threat of the Eurozone losing a member or two because some hedge funds decided to have a go at it.
The fundamental problem in the Eurozone is that individual member states cannot print themselves out of trouble and cannot devalue their currencies to solve their homemade fiscal problems. They surrendered those functions to the ECB, and the ECB has to keep those 19 countries in the currency union, come hell or high water.
One way for the currency union to break up would be for a fiscally “weaker” country, such as Greece, Italy, or Spain, to lose the confidence of the markets, and be confronted with spiking yields on their sovereign debt, to where those countries have trouble borrowing new money to pay off maturing debts and fund the current deficits and interest payments, while yields on German debt would remain relatively low.
This is what happened during the Eurozone Debt Crisis, which was resolved by a “whatever it takes” money-printing and NIRP promise from the ECB.
Now there is a different problem, raging inflation: Greece (12%), Spain (10%), Italy (8.5%), and Germany (8.2%). The ECB has to tighten monetary policies to get this under control, which includes rate hikes and shedding assets (QT).
As soon as this tightening became clear a few months ago, the spread between yields on German bonds and equivalent Italian bonds began to widen, and fears arose of a “fragmentation” of the Eurozone, if for example the Italian 10-year yield were to go to 10% while the German 10-year yield would only go to 4%, and Italy could then no longer afford to borrow, would default on its debts, abandon the euro, and return to the lira or whatever.
To prevent this scenario from happening, the ECB has come up with its new glue gun: the Transmission Protection Instrument. It essentially says that the ECB can target the bonds that it allows to roll off the balance sheet, and the bonds that it buys, based on yields in the weaker countries.
For example, if Italian yields begin to blow out, the ECB can buy Italian bonds, but let German, French, Austrian, and Dutch bonds roll off its balance sheet, and still keep its overall QT on track.
There are some special features on this glue gun:
The ECB hopes that the mere presence of the tool will keep markets behaving so that the ECB won’t even have to use the tool. The tool is a way of keeping markets from going haywire.
But if the yield-spread blows out for reasons that the ECB thinks are due to “country fundamentals,” rather than just markets going haywire, it can “terminate” the bond purchases, and the country would have to figure out on its own how to get markets to have confidence again, to get yields down.
The ECB will accept a yield spread, for example between German bonds and Italian bonds, but within some limits, which has been the case throughout.
When the ECB decides to reduce its balance sheet as a policy (QT), it will do so even if it has to apply the TPC within the balance sheet reduction. This could mean that if Italian yields threaten to blow out, the ECB may buy Italian bonds, but let its holdings of bonds issued by other countries roll off more rapidly, so that the overall balance sheet reduction would still proceed as decided.
The ECB set forth a long set of rules and conditions when a country would be eligible for this TPC and when it would not be eligible. These conditions include that countries must keep their debts on a “sustainable” path, and must have “sound and sustainable macroeconomic policies.” And if the yields jump because of “country fundamentals,” the ECB can terminate the TPC asset purchases.
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