The ECB is engaging in monetary financing and may have to face the legal consequences of that eventually, according to Hendrik Tuch, head of fixed income NL at Aegon Asset Management.
Tuch says while central bank bond buying programs in the past have had legitimate, treaty-sanction reasons for operating, this legitimacy may be waning with inflation now rising.
He warns this means, in effect, that the ECB could be in breach of EU treaties on monetary financing. This could potentially bring a legal challenge by hardline economists who disagree with its approach and file a complaint with a constitutional court, which could then be referred to the European Court of Justice, once the language around economic support no longer carries weight.
“It is very clear the market believes the ECB will continue to purchase a substantial part, if not all, of the future supply of European governments. Furthermore, the market expects the ECB to allow sufficient flexibility in the composition of these purchases to protect Italy and other high-debt countries from a substantial rise in yields.
“Just as with the current Pandemic Emergency Purchase Programme (PEPP), we believe the future Asset Purchase Program is expected to be aimed at keeping both government bond yields and spreads at historically low levels,” says Tuch.
“In my view, such considerations risk a challenge under the Maastricht Treaty if they are perceived to be motivated by the monetary financing of government deficits rather than meeting the ECB’s inflation target,” he added.
According to Tuch, Inflation is the most critical aspect of the economic backdrop that has changed since the previous financial crisis. Constant deflationary pressure over the past decade is now giving way to inflationary pressure and this should change central banks’ motivations for QE.
“With the ongoing economic rebound and rising price pressures, central banks face quite different circumstances compared to the previous decade,” says Tuch.
“The rising demand for goods, both during and after the pandemic, in combination with worsening supply bottlenecks, has resulted in a strong pickup of inflation. I believe that even though part of these price pressures will fade over time, the rising inflation numbers will force central banks to explain why they keep on buying bonds and grow their balance sheets.
“I expect the ECB will be particularly vulnerable to such comments, as there is scant support for purchasing government bonds in the EU Treaty. The EU Court of Justice considered the previous ECB purchase programs to be in line with the ECB’s mandate to maintain price stability.”
But Tuch warns that the ECB could soon face legal action from the ECJ, and the euphemisms of ‘supporting the economy’ from ECB board members won’t carry much longer.
“Most ECB board members still follow the line of ‘continuing monetary support to the economy’ in their speeches which is a vague enough statement to meet the EU Treaty test. But some statements hint at the argument that the ECB should continue to buy all the supply of government bonds,” he said.
“Some board members seem to want to keep the flexibility to deviate from the capital key in purchasing bonds, which flexibility was introduced in the current PEPP program. These are worrying signs ahead of the – in my mind – inevitable legal challenge with the Court of Justice,” Tuch added.
“Financial markets’ expectations of the announcement of a substantial and flexible purchase program in December are rising. I wonder whether the ECB will be able and willing to meet such great expectations.”