“A successful central bank should be boring”, a former Bank of England governor said more than 20 years ago. If any proof was needed that we are now in a radically different monetary era, one was given this week when the monetary policymakers of the world’s two largest economies arguably did their job by being as far from boring as could be imagined.
Within hours of each other on Wednesday, the European Central Bank held an emergency meeting and the US Federal Reserve enacted its largest interest rate rise in nearly 30 years. Both were dramatic moves — but while one drama was a reaction to markets, the other was in defiance of them.
Take the ECB first. It is never ideal for a central bank to hold an emergency meeting. But the euro’s central bank seems to have been able to use its “ad hoc” meeting Wednesday morning to get back on the front foot after being caught out by market reactions to its monetary policy meeting the week before.
That meeting came as investors had started to worry about how the ECB’s move towards tightening financial conditions would affect the borrowing costs of the fiscally weaker eurozone governments. Their disappointed hopes of a stronger commitment to contain widening sovereign spreads caused steep sell-offs: in less than a week, Italy’s borrowing costs rose by almost one percentage point.
The speed and scale of this change in market sentiment forced the ECB’s hand. The past week has brought back chilling echoes of the eurozone sovereign debt crisis. Apart from the sudden widening of yield spreads, the analyst community is full of chatter about “fragmentation risk”. Conditions have quickly become ripe for speculative attacks on pressured sovereigns’ debt and a repeat of the ugly politics of creditor-debtor country antagonism.
This is what the ECB had to arrest, having failed to foresee the rapid deterioration that its own earlier circumspection had caused. Its terse statement left no doubt that the bank has moved into a new phase. The emergency meeting did three important things. First, the ECB now explicitly states that its monetary policy is in fact being unevenly transmitted to different member countries — code for intervention in bond markets being justified. Second, it has moved from communicating the possibility of using its balance sheet reinvestments to combat excessive spreads to an express intention of doing so. And third, a new “anti-fragmentation” tool, mooted as an if-necessary resort for months, has now been ordered up from the technical staff.
Contrast this with the Fed, which met for its rate decision against the backdrop of an ongoing bear market in US stocks. Since the days of former chair Alan Greenspan, Fed observers have expected there to be a “Fed put” — that the US central bank would loosen policy to underpin falling markets. Even under current chair Jay Powell, this impression had been reinforced by the Fed’s massive injection of liquidity at the start of the Covid-19 pandemic.
That legacy was buried on Wednesday night, when the Fed raised rates by 0.75 percentage points and changed its forecast for future policy towards further tightening still. Concurrently, it will start running down its large asset holdings as bonds on its balance sheet mature. The clear intention is now to force inflation down, stock prices be damned — as Powell did not remark but might as well have.
Whatever drove their dramatic shifts this week, early signs are that both central banks are getting their way with markets. US stock prices ended the day higher after a volatile digestion of the Fed’s press conference. The ECB’s robust approach seems to be working; yields and spreads came down from their most recent heights after its emergency meeting.
This highlights the differences from previous crises. The ECB is now clearly in the game of containing spreads and, as important, its governing council is reasonably united behind this understanding. We are no longer in the world where former president Mario Draghi had to bounce his colleagues into action through dramatic unilateral “whatever it takes” statements. There is no doubt that the ECB has the means to prevent a fragmentation crisis; and the bank is finally working hard to dispel any doubts that it has the will. As for the Fed, it has cast off suspicions of being the market’s lapdog.
Markets, however, are not easily persuaded. If central banks are indeed taking a more muscular attitude, investors will not just roll over. We should expect more confrontations in the months ahead.
This column has been updated.