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Central banksAugust 3 2022

ECB introduces the Transmission Protection Instrument

The ECB’s new tool aims to ensure stable monetary policy in Europe, but will its high bar ever be cleared? James King reports. 
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ECB introduces the Transmission Protection Instrument

On July 21, the European Central Bank (ECB) launched the Transmission Protection Instrument (TPI), a tool designed to impart the ECB’s monetary policy “smoothly” across euro area economies. If required, the TPI will achieve this through unlimited sovereign bond purchases to minimise spreads between eurozone government bond yields. Yet the mechanism has attracted fierce criticism from monetary policy hawks, who claim the ECB has opened the door to direct monetary financing.

Changing economic conditions across the eurozone have contributed to the TPI’s development. As inflation has accelerated, the ECB has been forced to dial back its emergency monetary policy response to the Covid-19 pandemic by raising interest rates and winding down ongoing asset-purchase programmes. This, in turn, has caused government bond yields to spike as investors factor in higher inflation and tighter monetary policy conditions.

No good deed goes unpunished

This process of policy normalisation has exacerbated a series of long-standing problems facing the euro area. Chief among them is the health of Italy’s public finances, where public debt stands at around 150% of gross domestic product. With the ECB no longer hoovering up newly issued eurozone debt, it has caused borrowing costs to increase more sharply in Italy and other peripheral economies, as a result of the risk premia demanded by private investors.

For the eurozone, this presents something of an existential problem. And, from the ECB’s perspective, it “fragments” the effective transmission of monetary policy.

The increased cost of borrowing, especially for Italy, is heaping further pressure on already fragile public finances. Research from Bloomberg indicates that about a third of Italy’s outstanding government debt – equivalent to about €850bn – will need to be rolled over in the next four years. This will have to be financed at an affordable level if another sovereign debt crisis is to be avoided. In the past, the euro area has muddled through with different fiscal and monetary solutions, but in a high inflation environment fewer remedies are available.

“I’ve been saying for some time that the ECB and the euro area authorities are heading for some kind of tipping point. This does look like a more serious situation than anything we’ve seen in the past,” says David Marsh, chairman of the Official Monetary and Financial Institutions Forum.

This does look like a more serious situation than anything we’ve seen in the past

David Marsh

A hesitance to act

The launch of the TPI offers one response to this challenge. By pledging to tackle “unwarranted, disorderly market dynamics that pose a threat to the transmission of monetary policy”, the tool is designed to shield Italy, and other markets, from surging borrowing costs. The problem with this approach, however, is that it will fall on the ECB’s governing council to decide when to activate the TPI, in addition to determining when the market is pricing government debt at a level that it is “unwarranted”. 

“There is a clear difficulty in determining the fundamental reason for the spreads to be widening and whether the market is being irrational. The line between rational and irrational is very difficult to discern,” says Mr Marsh.

What’s more, the legality of the TPI is likely to be called into question. On July 29, Reuters reported that German academic Dr Markus Kerber was considering pursuing legal action against the ECB based on his view that the TPI constitutes “blatant state financing”.

TPI on standby

To get around potential legal challenges, the ECB has devised four criteria with which countries must comply before seeking assistance: adherence to the EU’s fiscal rules, an absence of severe macroeconomic imbalances, fiscal sustainability and sound macroeconomic policies.

The relative stringency of these criteria has given rise to the view that the ECB’s governing council hawks have little intention of using the TPI, at least for the time being. “When you have Joachim Nagel, president of the Bundesbank, saying that this is legally watertight, it’s actually a signal that the Bundesbank considers the bar to its possible use being so high as to more or less rule it out,” says Mr Marsh.

“The TPI is very unlikely to be used, at least until the Italian election [in September]. But the Bundesbank knows it is exposed to a risk here, so this is a gamble,” he adds.

Indeed, much will depend on the outcomes of Italy’s parliamentary elections in September following the collapse of Mario Draghi’s coalition government in late July. With early polls pointing to the possibility of a coalition government led by the right-wing, populist Brothers of Italy party, ructions in the country’s bond market could potentially deepen in the coming months.

If market sentiment concerning Italy’s debt sustainability deteriorates, the ECB may find itself in a difficult and highly politicised position.

“The ECB is heading towards taking a very big political decision on this. It could be that the ECB’s governing council would be giving either a thumbs up or a thumbs down to a future prime minister of Italy. So, it is putting itself in an enormously exposed political position,” says Mr Marsh. 

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