Inflation is affecting the whole world and the European Union (EU) is no exception. Following the lead of the Bank of England and the US Federal Reserve, the European Central Bank (ECB) recently decided to address this issue. However, as I will endeavour to explain, the decision seems contradictory in its terms since it has prompted a change in monetary policy in order to tackle inflation while also committing to continue purchasing of governmental bonds of some Member States, which arguably fosters inflation.
This contradiction highlights the vertical nature of the monetary union, in that the central bank’s policy-making seems very much tailored to its Member States on an individual basis, instead of focusing on eurozone-wide indicators. This state of affairs is difficult, if not impossible, to reconcile with the EU Treaties in their current form. Moreover, it can also put into question the effectiveness of the EU economic governance framework developed since the sovereign debt crisis.
In the press release following the Governing Council’s meeting of 9 June 2022, the ECB stated that, in May, inflation again rose significantly, to an annual rate of 6.8%, mainly because of surging energy and food prices, including the impact of Russian invasion of Ukraine.
Nevertheless, the ECB acknowledges that ‘inflation pressures have broadened and intensified, with prices for many goods and services increasing strongly’, which is projected to ‘remain undesirably elevated for some time’. These pressures are expected to subside in a context of future moderating energy costs, easing of supply chain disruptions and normalisation of monetary policy, which entails gradually ceasing quantitative easing.
As a result, the Governing Council took two major steps. First, it decided to end net asset purchases under its asset purchase programme (APP) as of 1 July 2022. This means that the ECB’s portfolio will not be expanded. Rather, it will be maintained, given that it will ‘continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it starts raising the key ECB interest rates (…) for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance’. Secondly, it decided to raise the key ECB interest rates by 25 basis points in July, eying a larger increment in September if the inflation outlook persists or deteriorates.
In order to dispel fears of a new sovereign debt crisis, the referred press release notes that in the event of ‘renewed market fragmentation related to the pandemic, PEPP reinvestments can be adjusted flexibly across time, asset classes and jurisdictions at any time’. Net asset purchases under the PEPP, which ceased at the end of March 2022, can be resumed, including the purchasing of Greek bonds (so that its economic recovery is not hindered by heterogenous transmission of monetary policy). Moreover, PEPP portfolio reduction will be managed in a way commensurate to avoid such fragmentation. To this end, new instruments could also be made available.
In the day after this decision was taken, southern European countries’ bonds jumped, hitting a two-year high for Greece and Italy. In fact, 10-year bond yield on Greece rose to 4.26%, climbing past the level it reached at the height of the Covid-19 pandemic, while Italy’s increased to 3.67%. Importantly, ‘the gap between Italian and German 10-year bond yields, a closely watched gauge of market stress, widened to 2.25 percentage points (…) the most since May 2020’.
Pursuant to this bond market disruption, less than a week later to its previous meeting, the Governing Council held an ad hoc meeting, after which it stated to apply ‘flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism’, which the ECB views as a precondition to deliver price stability. In essence, this means that PEPP portfolio reduction will possibly be rescheduled. In addition, it decided to ‘accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council’.
ECB (dual) primary mandate
In the Maastricht Treaty, Member States took an axiologically consequential decision. The mandate of the ECB since inception – now enshrined in article 127 (1) TFEU, bounds it to pursue price stability as the primary objective. In the latest strategic review, the ECB has set at 2% target in the medium-term. By attributing price stability a superior legal value, the unavoidable consequence must be that other concerns, for instance economic growth or unemployment rates, must be addressed only to the extent that they do not hinder the primary objective.
In order to counter low inflation and Member States bond market fragmentation, the ECB has enacted PSPP. Indeed, it was considered that asset purchases would provide the necessary liquidity and, consequently, increase inflation and promote stable market conditions.
On the contrary, in order to reduce high inflation, financial conditions need to be tightened. In the current context, where the inflation rate more than trebles the reference value, the ECB is doing that by increasing key interest rates. However, at the same time, it is not only maintaining its balance sheet but also returning to net purchases. In essence, the ECB is, on the one hand, tackling inflation and, on the other hand, taking measures that, in a way, promote inflation. Therefore, this course of action seems contradictory and difficult to reconcile with the monetary legal value hierarchy defined by the Treaties.
Pursuing both objectives may prove to be difficult. On the one hand, it might reignite old tensions. Price stability is the ECB’s overring objective and, in a period of high inflation, most eurozone Member States will support tackling it strictly. On the other hand, it fosters market distress within the countries most in-need of the ECB’s presence in the secondary sovereign debt market, given the monetary policy trap: while a tight policy is necessary at the moment in order to counter inflation, liquidity is also needed for some bonds. This may well prove to be an impossible balancing act, not least because one of the most precious central bank’s assets to fight inflation is eroding at a rapid pace: its credibility.
In my view, the referred decisions taken by the ECB derive from a sort of shadow mandate underlying its action. Indeed, fearing that the rise of certain Member States’ debt interest rates could inevitably lead to a return to previous national currencies and, potentially, a eurozone break-up, the ECB is informally assuming a dual primary mandate: ensuring price stability and eurozone survival.
Crucially, the described course of action illustrates the paradox of EMU integration in its current form. I am not referring to the well-known division of competence mismatch between the Union and Member States, but to the fact that the legal values enshrined in the Treaties no longer adequately and accurately reflect societal needs. It is by now clearer that, in the current institutional setup, some Member States need the ECB to survive in the monetary union: after the announced policy on June 9th, it took only one day to bring back sovereign debt crisis fears.
A look into the US offers useful insight for EU economic governance framework. Interestingly, if we compare EU Member States with US States’ bond yields, the situation is not very different, as they also vary. However, despite both being lower-level units within a larger governance space, this financial differentiation does not prompt sub-national bond-buying by the US Federal Reserve, as there is no fear of dollar disintegration. For instance, from 13-15 June 2022, California’s yields on issuances were around 3.8%; Illinois’s at 4.8%; Florida’s at 2.4%, New York’s at 3% and Texas’s at 2.5%. Moreover, different US regions have different inflation rates.
However, in the EU, the issue of monetary policy fragmentation was already judicially vetted in Gauweiller. In its ruling, the CJEU stated that, first, OMT was within the monetary realm because it intended to safeguard the singleness of a policy that indeed intended to be single. Second, the objective of safeguarding an appropriate transmission of monetary policy was likely to attain the referred singleness. Be that as it may, it is doubtful that the concept of ‘singleness’ of monetary policy should be interpreted to mean that financial conditions must be somewhat replicated in each Member States. The case of the US States indeed suggests otherwise. Therefore, in my view, article’s 119 (2) TFEU reference to ‘single’ monetary policy should be interpreted not in light of its effects in each Member State individually, but as a reference to the existence of one policy for the Union as a whole.
As Cruz Vilaça argued regarding the Bundesverfassungsgericht’s ultra vires decision, ‘[i]n a complex structure like that of the European Union – a sort of plural constitutionalism at various levels – the existence of competing “constitutional” courts in the same space cannot be accepted, in order to prevent the creation of a Union of variable geometry and, at the limit, generalized institutional chaos’ (my translation). As a result, the author argues against judicial fragmentation and in favour of the principles of direct effect and primacy as a means to achieve the integrity of EU law. Mutatis mutandis, the same reasoning should be applied with monetary policy, whereby fragmentation in design, not in effects, should be avoided.
The main concern going forward is that accommodative monetary policy has started in 2010 and cannot go on forever. First, because it can hinder the rule of law, as the ECB is consistently on the grey area of legality. Second, because of moral hazard concerns. As I explained elsewhere the market is expecting the ECB to constitute a floor on Member States bond markets. Knowledgeable of this, there is the risk Member States are relieved from concern to discuss and implement reform in the different national areas.
The consequences of the ECB’s decision also highlight a potential notable failure of EU economic governance. Pursuant to the sovereign debt crisis, tighter constraints on the autonomy of national economic and fiscal policies were introduced, by way of the Six-Pack and Two-Pack. The disciplining effect, ensured by close supervision by the Commission, was intended to induce more confidence in the markets. However, overnight the limited effectiveness of the reinforced SGP was exposed.
It is now clearer that reduction of debt yields in bond markets were more due to ECB’s liquidity support than to an economic governance framework based on tight supranational surveillance. While intended to foster compliance with fiscal indicators, national fiscal improvements in recent years have been given a substantive push by monetary policy, in the form of more fiscal space from interest savings, but also national central banks profit sharing to shareholders (the States).
With monetary policy expectably changing, it is normal to caution on what the future might hold. Therefore, at this point, one cannot blame the market for doing what was accused of not doing in the past: measure sovereign risk. Moreover, at the height of the sovereign debt crisis, Member States agreed to relinquish significant autonomy in these realms – the so-called conditionality – in exchange for ESM assistance, if needed, and ensuing ECB intervention in secondary markets. In this sense, it will not be easy for the EU to continue to justify the existence of a supranational framework which places significant constraints on economic and fiscal policies’ decisions making if, at the end of the day, the objectives are apparently not achieved and ECB intervention is discontinued.
In conclusion, the recent ECB’s decisions of 9 and 15 of June 2022 highlight the dual primary mandate of the institution. Although Member States did not intend for it to hold this purpose, the CJEU green-lighted it in its case-law. However, it is doubtful that a central bank should embark on such a task, most of all for moral hazard concerns, but also because, with the objective of preventing fragmentation effects in Member States, there is a risk of fragmentating monetary policy design, by tailoring it with sometimes seemingly contradictory tools and objectives.
As the judicial conflict with national constitutional courts and a comparative look at the US teaches, institutions must function at the level for which they were designed for. In my view, this objective is currently not being achieved by the ECB, as it is increasingly clear that a vertical relation was established with Member States, one that is legally unsound, places economic perils and is politically sensitive.
Moreover, the EU economic governance framework could become under pressure. In its current form, it only reduces Member States sovereign powers with little-to-no positive results to deliver.