What to expect from ECB’s new mechanism?

The ECB never had to use the OMT in the end

But does talk of such a mechanism actually risk creating the market turmoil that the ECB’s alleged plans are designed to rebuff?

It seems fair to say that the ECB’s credibility has been badly damaged by the surge in inflation. But, of course, that’s true of other major central banks such as the Fed and Bank of England. They have all underestimated inflation and are running to catch up. However, the stakes are higher for the ECB than elsewhere and this is probably why the Bank is thinking about designing an emergency mechanism should yields start to soar.

The ECB is presumably concerned that its ending of net asset purchases, which is likely in Q3 and is needed to combat rising inflation, will deprive government bond markets of the huge purchases that the ECB has done over the past decade, or more; a figure that is now close to EUR6.5tr.

However, other central banks will likely trim their balance sheets in similar ways; the Fed, for one, seems likely to go much faster than the ECB, but we’ve not heard about any emergency mechanism here. So, why does the ECB seemingly need an emergency mechanism while other major central banks do not?

History is the key here as the ECB is still haunted by the memory of the euro zone debt crisis just over a decade ago which saw yields in many countries soar and some, like Greece, almost forced out of EMU altogether. This bought about former ECB President Draghi’s pledge to buy unlimit ed amounts of troubled bonds, termed Outright Monetary Transactions (OMT) as part of the famous “whatever it takes” promise to support EMU. This pledge worked wonders with the private sector regaining confidence and so closing bond spreads.

The ECB never had to use the OMT in the end; the mere promise of unlimit ed bond buys did the trick. But if it did the trick then, why can’t it do the same now if yields soar? For one thing the situation is different as the risk to bonds now seems one of generalised inflation across the region rather than specific debt problems in countries such as Greece and Ireland as it was back in 2010-12.

Secondly, and related to this, OMT purchases were to have been conditional on fiscal austerity in the recipient country. But while that might have been reasonable in a debt crisis it is seemingly less valid in an inflation crisis. Another issue is that the OMT does not solve the fundamental problem which is that euro zone countries issue debt in euros but don’t print euros. Hence, they are always beholden on the ECB to act as a lender of last resort and it is still not clear that this is an unconditional promise given the austerity requirement of the OMT and, more generally, the fact that the ECB might just not choose to support a troubled country.

The “solution” to this problem is to have a central authority issue common debt and some progress has been made on this front with the EU’s EUR807bn Next Generation plan which is funded by the issuance of joint debt. But the euro zone is still a very long way away from a common bond market.

As a result, financial markets will remain wary that debt problems can spiral into solvency issues must faster in EMU than the likes of the US or UK, because both the Fed and BoE can print dollars and sterling to monetize debt if push comes to shove. Perhaps, the saving grace right now is that countries face an inflation problem not a debt crisis. But the latter can quickly follow the former if inflation forces yields to rise sharply and government financing costs to surge. It seems as if the ECB wants to pre-empt any such risk and, at the same time produce a better emergency plan than the OMT. This is to be welcomed.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said the only risk it would seem is that by reminding the market that many of the vulnerabilities that led to the 2010-12 debt crisis still remain, the ECB could be tempting fate. Bond spreads are already widening even before the ECB lifts rates and ends bond buys. “Our best guess is that this spread pressure will continue whether the ECB comes up with a new emergency plan or not”, Mr. Steve Barrow said.