The European Central Bank (ECB) is designing a tool for an orderly transmission of policy in the euro zone. It could be designed with limits on its size, to be increased if needed, or on the maturity of bonds to buy. Countries will be subject to some degree of conditionality and the conditions in which the tool will be used will remain a grey area.
A unanimous decision by the ECB’s Governing Council to buy unlimited amounts of sovereign bonds across the maturity spectrum when their interest rates increase in a disorderly way could be the most powerful announcement to prevent fragmentation this summer, but not necessarily the most credible announcement, wrote Barclays analysts in a report that considered the design of the anti-fragmentation tool (AFT).
If the ECB were certain it would never need to activate the anti-fragmentation tool by announcing a facility with unlimited purchase capacity, it would certainly do so. But, in the event that the ECB ever needed to use the AFT, unlimited purchases of government bonds would likely not meet the proportionality criteria.
The ECB could face legal challenges brought about by citizens of some member states as it has happened in the past, ultimately preventing the use of the AFT, as its potential benefits of preventing market fragmentation could be outweighed by costs in terms of: (i) credit risk the Eurosystem would hold on its balance sheet; (ii) a potential breaching of the no bail-out clause and the Treaty prohibition of monetary financing; and (iii) the and ability of the ECB to bring down inflation to 2%, the ECB’s primary objective. Also, importantly, the commitment of unlimited purchases would likely turn to be time-inconsistent, as presumably disagreement in the GC would rise as the ECB buys more bonds issued by high-debt countries.
Due to these trade-offs, a facility with a large pre-specified capacity and a pledge to expand it if needed or a one that implicitly limits the amount of purchases for each sovereign by constraining the maturity of bonds that could be bought, as in the case of the OMT (outright monetary transaction) that targets only bonds with a residual maturity up to three years, could be a compromise the Governing Council might settle on. After all, this could be a more credible, although initially disappointing, outcome.