The governing council that sets rates for the European Central Bank sits six members of the executive board and the 19 governors of the eurozone’s national central banks. I bet most of them have read George Orwell’s allegorical fable Farm and his famous phrase: “All animals are equal but some animals are more equal than others”.
At the risk of sounding flippant, so it is with the ECB. Isabel Schnabel, a board member from Germany, is one of the most influential voices on the farm. Yannis Stournaras, the governor of Greece, although one of the most experienced members of the council, having been in office since 2014, has less influence.
so when Schnabel spoke Last month at a meeting of central bankers in Jackson Hole in favor of strong action against inflation, the markets sat up and listened. They noted similar comments from François Villeroy de Galhau, the powerful French governor. But they gave less weight to a more moderate approach. speech delivered by Stournaras a few days later at the European Forum in Alpbach.
For this reason, the generalized market expectation is that the ECB will raise its main policy rate by 0.75 percentage points on Thursday. That would equate to the highest increase in the bank’s 24-year life and would follow a fairly aggressive 0.5 percentage point increase in July.
Is Stournaras advocating a more cautious approach simply because it would be in the national interest of Greece? I’m sure you’d say no. Like all members of the ECB council, she must analyze the economic outlook for the eurozone as a whole.
However, financing conditions are beginning to change in the region, and Greece is among those affected. The yield on 10-year Greek government bonds has risen since late August above 4 percent, compared with around 1.5 percent on benchmark German bonds. The Italian yield is close to 4 percent.
Neither Greece nor Italy are experiencing financing difficulties. We are far from the time, if it ever comes, when the ECB’s board might consider activating its Transmission Protection Instrument, its new anti-crisis bond-buying tool.
Under the TPI, the ECB can potentially buy unlimited amounts of debt over one to ten years if it believes financing conditions are fragmenting. From a monetary policy perspective, fragmentation means “a sudden break in the relationship between sovereign yields and fundamentals”, Schnabel said a French university audience in June.
Much uncertainty surrounds the legal basis for using TPI, as well as the criteria the ECB would apply in deciding whether to act. At a minimum, one country would be eligible for TPI only if it complies with the EU fiscal rules, does not have severe macroeconomic imbalances and meets the conditions attached to the EU post-pandemic recovery fund.
However, disruptive market conditions can arise from various sources. One is the perception that the ECB’s aggressive interest rate hikes will hurt economic growth prospects in countries with extremely high levels of public debt, such as Greece and Italy.
A second could be a political rupture, such as the expected victory in the September 25 elections in Italy for a right-wing bloc that is showing signs you can try to rewrite the conditions of access to the EU recovery fund. This would represent a break with the policies of the national unity government of Mario Draghi, that collapsed in July.
A third source of potential shocks is that some investors see high-risk, high-return opportunities in taking positions that benefit from widening yield spreads between different euro area government bonds. In an incomplete currency union like the eurozone, which still lacks a full fiscal, banking and capital markets union, these opportunities exist just as they did when Greece and other countries fell into trouble more than a decade ago.
At the ECB, the prevailing view seems to be that inflation outweighs other concerns for the time being. The eurozone’s headline annual rate rose to 9.1 percent last month and core inflation hit 4.3 percent. With central bankers around the world under fire for misjudging inflation risks, the bank may feel the need to defend its reputation with strong action.
However, Stournaras made a good point when he said that so far there was little evidence that rising inflation was causing a spiral in wages and prices. For the second quarter, the growth in negotiated wage agreements it came to just 2.1 percent.
In that sense, it may be prudent for the ECB, if it raises rates by 0.75 percentage point, to make it clear that this is an unusual initial step aimed at lowering the level at which it eventually stops raising rates, presumably the next year.