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What is not said is more important to what is said

Jean-Pierre Dumas

June 30, 2023

If you read the FT Marin Arnold June 28 and Martin Arnold June 29 and other leading newspapers, you will see that the monetary policy debate is reduced to three points.

- Should central banks (CBs) raise their interest rate and by how much?

- Are central bankers communicating well enough to manage expectations?

- The labour market is still too tight and wage-price spirals explain inflation (always the Phillips curve).

These are important points, but, in my view, we are missing the most important one. Why is the ECB still buying government bonds (QE) and is QE a source of inflation? Why do these eminent journalists systematically forget to mention the role and importance of QE as a monetary tool?

Robin Brooks and David Marsh have published an important article in the OMFIF (Official Monetary and Financial Institutions Forum's blog): : ECB -bond-reinvestments-muddy-Europe's-fiscal-rules which addresses these points. For the first time, they consider the role of the ECB’s reinvestment of bonds acquired under its 2020 pandemic emergency purchase programme (PEPP). “Net Eurosystem buying under PEPP ended in March this year, but PEPP reinvestments are continuing – and have been significantly skewed towards supporting the more indebted members of monetary union”.

They argue that the ECB's reinvestment of the PEPP's principal distorts capital market interest rates in the euro area, which "obscures the true cost of public debt in the euro periphery". This is, I suspect, the ECB's hidden objective, which is to artificially prevent an elevated spread between highly indebted countries and Germany. Their communication, limited to the interest rate, works perfectly, since the FT, TE never mention the role of the continuation of QE on inflation.

R. Brooks & D. March provide two fascinating figures in their article showing that the respective central banks of Italy and Spain are the main buyers of TB since the start of QE introduced in 2015, they have driven out TB purchases by foreigners, banks and households. In doing so, they are preventing the bond vigilantes from doing their job (dumping the bonds of fiscally irresponsible countries).

We can see in figures 1 & 2 that the two CBs from Italy and Spain continue to quietly buy TBs from their respective countries (we would have liked to see the same graph for France).

According to R. Brooks & D. March, the continuation of QE explains the narrowing of the spread for peripheral countries. “The fall in Italy’s spread is – by historical standards – highly unusual. Italy’s high debt-to-GDP means that the spread should rise when German and global yields rise.” Therefore, the ECB's continuation of QE leads to distorted interest rates that do not reflect market forces.

But our point is that QE through massive bond buying since 2015 in the euro area (and since 2008 in the US) is one of the causes of inflation; if the bond buying continues inconspicuously, the ECB is not doing its job of controlling inflation.

Yes, monetary financing in the euro area is explicitly forbidden by the European treaties. But if the ECB's QE has been very important in indirectly financing new net debt issuance in the euro area, then it gives a strong incentives to governments (the same argument applies to the US) to run high budget deficits (sometimes higher than necessary), since governments know well that the central banks of their respective countries will buy (on the secondary markets) all the bonds they issue. I think that this is tantamount to hidden fiscal-monetary financing.

If the ECB is serious about fighting inflation, it must raise its (still too low) interest rate (a little), accept that there is a time lag between the interest rate effect and inflation, and it "should bring forward the date for ending PEPP reinvestments" and abolish the "transmission protection instrument", because all these instruments have as their ultimate objective not only to shield vulnerable countries from market signals, but also to send the signal that the fiscal party is not over.

There should be some coordination between monetary and fiscal policy. Some lax governments, shoot up with deficits, are reluctant to understand that we have reached a limit to the level of debt, so the only way for the central bank to influence fiscal policy is to freeze the QE policy; if it does not stop it completely, it will continue to send the wrong signals to governments and markets, and the central banks will be forced to rely only on interest rate policy, risking raising them higher than necessary with the risk of triggering a financial crisis in rich and poor countries.

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