The European Central Bank has joined, albeit rather belatedly, the peloton of global central banks tightening policy even as it faces mounting growth risks. The rate rise was more hawkish than consensus (25bps) and market expectations (~33bps) and what it had previously signaled through forward guidance (25bps). With inflation meaningfully above the central bank’s target over the course of the next year, the ECB has been pushed in a corner and will be hiking aggressively in a highly recessionary economy.  

The ECB judges that further normalisation of interest rates will be appropriate, although the decisions will be based on a meeting-by-meeting and data-dependent approach.

Markets are pricing in ~170bps of rate hikes by the end of the year and ~200bps by March 2023, potentially making this the swiftest hiking cycle since the inception of the euro. The room for disappointment is large and the downside for the euro sizeable.

On the Transmission Protection Instrument:

More importantly, the focus today was on the Transmission Protection Instrument (TPI), the anti-fragmentation tool to contain peripheral spreads from blowing up in the face of tighter policy.  The TPI appears to be a permanent tool in the ECB policy toolkit that can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the EA. The size of purchases is unlimited ax-ante. The tool is meant to aid the ECB achieve its price stability mandate.

There is a whole lot of ECB-style constructive ambiguity in deploying the TPI. The eligibility, activation and termination criterions are all open to judgement and General Counsel discretion. The timing of the announcement of the TPI has coincided with the widening of BTP-Bunds spreads on the back of heightened political instability in Italy and raises a few interesting questions  –

• What would the ECB do when spreads are widening due to political concerns (as it is now)?
• How does the ECB define an ‘unwarranted’ widening of spreads? In other words, how does the ECB determine whether the rise in spreads is speculative or determined by fundamentals?
• The role of sterilization to distinguish TPI purchases from a net easing in policy against the backdrop of policy normalisation

In any case, we think the TPI is more likely to address the symptom (wider spreads, higher risk premia) rather than the cause (underlying differences in competitiveness, growth potential, debt levels, fiscal governance) and may have a muted impact on keeping spreads lower for longer. In the absence of concrete details, we think markets will test the ECB and while the approval of the TPI was unanimous, the implementation will be rife with concerns about monetary financing.

Read more: https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.pr220721~973e6e7273.en.html