© ANP
On Thursday, 21 July the European Central Bank (ECB), in addition to a 0.5% interest rate increase, announced the transmission protection instrument (TPI). The TPI is a monetary instrument intended to secure a balanced transmission of monetary policy throughout the euro area – which is a prerequisite for achieving price stability. In concrete terms, the ECB wants to avoid a situation where a policy rate increase would have a disproportionately greater effect in one country than in another. The instrument is therefore not aimed at eliminating interest rate differences between countries caused by structural differences between those countries. This DNBulletin explains why this instrument is necessary.
The ECB is responsible for maintaining price stability in the euro area. In order to steer the inflation rate, it uses various instruments, such as adjusting policy interest rates. When the ECB adjusts the policy rates, this impacts the interest rates that governments, non-financial corporations (NFCs) and households pay through financial markets and banks. Ultimately, this affects the economy and inflation. This process is called monetary transmission.
On Thursday, 21 July the ECB started to raise its policy rates. It is important that the transmission of this adjustment is to some extent controlled and comparable in all euro area countries. This does not mean that all interest rates must develop in exactly the same way, however, because often risk premia (the compensation that investors demand for holding risky bonds) also rise when the risk-free interest rate increases. It is therefore not surprising that after a policy rate increase, the sovereign rates in countries with a high public debt rise more sharply than, for example, the Dutch rate. The ECB monitors this effect, since the interest rates that businesses and households pay in these countries typically also move with the increase in sovereign rates. Figure 1 illustrates this effect for Italy and the Netherlands. All Italian capital market rates rose more sharply than their Dutch equivalents after the ECB monetary meeting last June, when it was announced that interest rates would be increased in July. Not only Italian sovereign rates rose more sharply, but so did the interest rates that Italian NFCs and banks pay for their (subordinated) debt. In the longer term, too, there is a clear correlation between government and corporate rates in the various euro countries (Figure 2).
© DNB
Source: Bloomberg. Figure 1 shows the response of Italian and Dutch interest rates to the ECB monetary meeting in Amsterdam on 8-9 June 2022. The corporate rate indices contain bonds of various companies with various credit ratings headquartered in the respective country. Banks' funding costs refer to an average interest rate on AT1 bonds of the 5-6 largest banks per country (maturity of AT1 debt is perpetual). Figure 2 shows the correlation between corporate and sovereign rates by country. A figure adjusted for movements in the risk-free (swap) rate shows a similar trend. The coefficient of the regression line is about 0.65 and is a trend line based on all observations in all countries.
To a certain extent, this is an inevitable result of market forces. However, there is a risk of markets overreacting, after which rises in interest rates become disorderly and self-reinforcing. In countries with very high public debts, the initial rise in sovereign rates may spark concerns about repayment capacity, a further steep rise in interest rates, and so on. Even if the initial rise was appropriate, the dynamics may escalate. Contagion effects, in which interest rate increases in several (vulnerable) countries reinforce each other, cannot be ruled out either. At the same time, capital inflows to safer countries (such as the Netherlands and Germany) may lead to falling interest rates there. As a consequence, the ECB will have less control over the interest rates paid by households, NFCs and governments in the euro area, and fewer possibilities to steer inflation.
Inflation is currently running high worldwide. It goes hand in hand with economic and political uncertainty surrounding, for example, natural gas supplies and the war in Ukraine. Especially in this situation, there should be no doubt about the ECB's willingness to raise interest rates as high as necessary to get inflation back to 2%. Concerns about an excessively unbalanced monetary policy transmission, in which a significant part of the euro area would face disproportionately rising interest rates, could lead to such doubt. This is why the ECB decided to announce the TPI at this particular moment.
The TPI allows the ECB to purchase sovereign bonds issued by countries which face sharp interest rate movements that are not justified given their economic fundamentals and that jeopardise monetary transmission. If necessary, the programme may be extended to include corporate bonds. The scale of possible purchases depends on the severity of the situation, but is not limited in advance. However, any TPI interventions will be temporary and will end when the markets calm down or when the ECB's Governing Council finds that the continuation of the market turmoil is driven by fundamental factors. Unlike previous (partly) transmission-oriented instruments, such as the pandemic emergency purchase programme (PEPP), the aim is not to ease the monetary policy stance. Hence, the ECB will address the impact of any purchases on the Eurosystem's bond portfolio and ensure that there is no (persistent) balance sheet growth. The maturity of bonds to be purchased is capped at 10 years.
To prevent the ECB from responding to fundamental interest rate movements and prevent countries from trying to abuse the instrument, a list of eligibility criteria has been established. First of all, they ensure that countries do not violate European fiscal rules and that their public debt is sustainable. The ECB will take into account debt sustainability analyses by external parties such as the European Commission, the European Stability Mechanism (ESM) and the International Monetary Fund (IMF). Countries will also have to comply with the rules regarding macroeconomic imbalances (MIP) and they have to respect the agreements made in the Recovery and Resilience Plans (RRP) from the European Recovery and Resilience Facility. Subject to these eligibility criteria, the ECB’s Governing Council will, in the event of market turmoil, decide on the appropriateness and proportionality of an intervention based on a broad set of market and transmission indicators.
For transmission risks arising from the pandemic, reinvestments under the pandemic emergency purchase programme (PEPP) remain the first line of defence. The Outright Monetary Transactions (OMT) programme also remains available as the ultimate backstop for countries that meet the relevant conditions. The conditions and application of PEPP, TPI and OMT are tailored to the specific causes that can lead to activation. With these three instruments, the ECB has a well-stocked toolkit to secure the transmission of monetary policy and raise interest rates as far and as fast as necessary to curb inflation.
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