PIMCO: Tightening ECB policy increases risk of financial accident

Her Eleftherias Kourtali

The exit of the ECB from the bond market program and the increase in interest rates increase the risk of financial disaster, especially as debt levels in the eurozone have risen during the pandemic and as many other central banks tighten their policies at the same time, he points out. Joachim Fels, financial advisor to PIMCO in his analysis. He points out that the risk of another policy mistake has clearly increased and points out the reasons why the risks of an early tightening would outweigh the benefits.

According to Fels, the European Central Bank’s aggressive turn last week, along with the Bank of England Monetary Policy Committee, which was just one vote away from raising interest rates by 50 instead of 25 basis points, made it very clear that global Central banks led by the Fed US are determined to react strongly to decades-old inflation.

With Lagarde no longer ruling out interest rate hikes this year and showing that recent upward surprises from inflation have led to “unanimous concern” on the board, markets are now pricing the end of net asset purchases this year up 50 basis points. interest rates until the end of 2022, thus indicating a departure from the policy of negative interest rates.

Of course, such an action by the ECB could be justified as appropriate risk management, but the events of 2008 and 2011, when the ECB was forced to reverse seemingly appropriate interest rate hikes in the short term due to the financial collapse, are a warning story. .

According to Fels, There are two arguments in favor of reducing easing monetary policy in the euro area in the current context.

The first is risk management in the face of nominal inflation 5.1% which exceeds previous expectations and is well above the symmetrical target of 2%. While the ECB has good reason to expect inflation to fall sharply on its own this year and next, these expectations may turn out to be overly optimistic. The higher inflation remains, the greater the risk that inflation expectations will rise above the target. This may then require a sharper tightening that could cause a recession.

The second reason is political: Negative interest rates are extremely unpopular, especially as banks have made progress in passing them on to more and more depositors. The longer negative interest rates last, the more public support for ECB policy will be undermined.

However, in order for the ECB to emerge from negative interest rates, it will have to overcome an obstacle it has imposed in the past. He has stated that he will first stop QE and soon after that he will raise interest rates. The PEPP ends in March and the net purchases under the APP that will follow, from 40 billion euros per month in the second quarter, will be reduced to 30 billion euros in the third quarter, and to 20 billion euros “as needed”. . Thus, if the ECB wants to raise interest rates before the fourth quarter of 2022, it would first have to change its guidance and announce the early termination of the APP. This could be done in March but a change of direction always comes at a cost to make the ECB less credible.

The PIMCO financial advisor points out that, while the above arguments for a change in monetary policy should not be easily dismissed, the risks of an early tightening would outweigh the benefits, for three reasons.

First, it is not certain that tightening policy in an environment of a huge supply shock caused by Covid-19 and rising oil prices is a sensible policy. Demand in the euro area is more subdued than in the US as fiscal policy has been less expansionary and pandemic-related restrictions have been tighter. Also, the increase in nominal wages has remained very subdued so far, which together with the high inflation implies a significant reduction in the real disposable income of households. Stricter monetary policy would therefore be an additional blow.

Secondly, tightening monetary policy would run counter to the ECB’s stated goal re-establish long-term inflation expectations around the symmetric 2% target. In fact, five-year forward inflation expectations, which were still below target last year despite falling last year, fell in response to the ECB’s shift at last Thursday’s meeting.

Third, the end of net asset purchases and rising interest rates increase the risk of financial accidents, especially as debt levels have risen during the pandemic and as many other central banks tighten their policies at the same time. Given its “one currency, many nations” institutional structure, the euro area remains at risk of financial fragmentation between its many government bond markets and its national banking systems. While much of this risk could be mitigated with the help of PEPP’s flexible reinvestment program and targeted TLTROs for banks, the risk of self-fulfilling mass exodus from government bonds and banks remains real, especially if the ECB is to fight a real or perceived inflation problem.