16 November 2011

FT: ECB under strain as political masters bicker

The ECB intervened in government bond markets, which curbed rises in Italian debt yields. The euro's monetary guardian, however, has refused to become explicitly the “lender of last resort” to governments.

Two weeks ago, Mario Draghi, the ECB’s new president, insisted the bank’s actions would be limited, temporary, and focused on ensuring its interest rate decisions were “transmitted” via financial markets to the real economy. He has not spoken publicly since. Calls for bolder action are mounting, however. Peter Bofinger, an adviser to the German government, says ECB targets for the interest rates paid by governments would be a logical extension of the traditional control that central banks have over short-term interest rates. In the face of a possible run on sovereign bonds, “you have to do everything needed to keep this core [market] stable”, he says.

An alternative would be for the ECB to set limits on the “spread” between interest rates on German and other government bonds, which would fit with its objective of ensuring the effective “transmission” of its interest rate decisions. Such a step might even be cheaper than its current, unannounced intervention – if financial markets believed the ECB’s targets were credible, it might not actually have to buy many bonds at all.

The legal basis for the ECB’s bond buying programme, launched in May last year, is treaty articles giving it freedom to buy or sell assets in the open market in pursuit of its objectives, although the treaty prevents “monetary financing” by banning the bank from buying bonds directly from governments. “There is no limit on the volume of intervention – either from a legal point of view or from a technical point of view”, says Stephane Deo, European economist at UBS.

Instead, the constraints on the ECB are more political. The bank fears weakening the incentives for governments to implement crucial fiscal and economic reforms. Even after the resignation of Silvio Berlusconi as Italy’s prime minister, the ECB will want to keep Rome focused on implementing measures to boost investor confidence.

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