Leaky Pipes

• “Non-decisive” dataflow shifts the emphasis to the duration of restrictive monetary conditions: a “plateau” rather than a “peak.” It can still be painful though as the long end of the curve is adjusting.
• The Euro area’s complex “pipeworks” – the ESM and the ECB’s balance sheet – are calling for attention again.

The absence of any smoking gun in the recent dataflow in the US, either pointing at “runaway inflation” or conversely at a hard landing of the real economy, is supporting the new emphasis put on the length of time monetary policy conditions will be kept restrictive, rather than on how much further the tightening needs to go. A plateau rather than a peak, to borrow words from Francois Villeroy de Galhau. Being patient and gently but surely taming inflation by maintaining restrictive conditions for longer than initially expected but without going into stratospheric territory can help mitigate financial stability risks. While such an approach may be optimal from a macro point of view, it can still be painful marketwise, as even the long end of the curve is adjusting to the idea of central banks keeping rates significantly above equilibrium possibly over several years.

Tough monetary conditions for long will test the Euro area’s institutional set-up. The monetary union (EMU) operates as a very complex and evolving set of “pipe-works”. 10 years ago, the sovereign crisis triggered much institutional creativity, and the European Stability Mechanism (ESM) was a key source of progress. The current dispute around its reform, revived by Italy, is a reminder that EMU is still in a state of flux. We explore here what the decision by Rome to postpone the ratification of ESM 2.0 reveals about the dividing lines across the union.

Still, the Eurosystem – the ECB combined with the national central banks – is EMU’s most important pipework. The massive growth of its balance sheet is what kept it together. Yet, the legacy of QE – massive deposits at the Eurosystem now paid a substantial rate - is also taking the form of significant income loss for the central bank, and ultimately governments. With the bulk of the contraction brought by the early repayment of the TLTRO now executed, we explore other avenues to shrink the balance sheet. The most obvious option – bringing forward the end of the reinvestment of PEPP – would come with some financial stability risks.