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ECB’s nixing of TLTRO is too hasty

The European Central Bank’s retreat from monetary easing should be nuanced and gradual

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The European Central Bank has been criticised for taking too long to start tightening monetary policy to rein in this year's rampant inflation. Many of those barbs are unfair — the ECB was still in easing mode when inflation struck, and it has spread like wildfire, much faster than almost anyone expected.

But this week the ECB made a tightening move that may have overstepped the mark.

Thursday's 75bp interest rate rise had been baked in to market expectations. A keen point of interest for ECB watchers was what it would do with the Targeted Longer-Term Refinancing Operations.

A narrowing of this generous funding window for banks had long been expected, but the ECB has slammed it shut abruptly.

For much of the past decade the TLTRO has been there, offering unbeatable funding to the banking system.

It was initially designed to encourage lending during the long period of sluggish growth after the financial crisis. When Covid-19 struck, the programme was ramped up to €2.1tr and the lowest borrowing rate cut to minus 1%. That effectively handed the banking system a substantial risk-free profit.

But on Thursday the punchbowl was hurriedly withdrawn.

From November 23 the cost of TLTRO financing will rise to the deposit rate of 1.5%. It could go up again to 2% with an anticipated 50bp interest rate rise in December.

At that point the ECB will also deliberate about how to go about cutting its bloated €5tr balance sheet, by potentially running down its Asset Purchase Programme.

It might even follow the Bank of England’s lead and actively sell bonds.

But with Europe facing a fierce winter of war and energy crisis, it is difficult to conceive how banks are going to keep credit flowing.

The International Monetary Fund predicts that German GDP growth will fall to minus 0.3% next year, Italy's to minus 0.2%. This seems optimistic.

Conventional thinking is that the forthcoming recession will temper inflation, but these are not conventional times.

If energy prices remain stubbornly high, as well they might, there’s a fair chance inflation will exceed the ECB’s 5.5% forecast — even as the economy plunges into contraction.

And since much of the free TLTRO money was invested in higher yielding government bonds, there’s also a fair risk that when it is removed, banks will sell those bonds, stimulating fragmentation risk in European government bond markets.

That could force the ECB to try out its untested — and likely politically controversial — Transmission Protection Instrument to buy weaker sovereign bonds.

If the ECB is to avoid getting itself into an even deeper quagmire, which could force an ugly and rapid reversal in policy, it will need to tread a lot more lightly.

If the scotching of TLTRO proves to have been harmful, a deft rebalancing of the ECB's repo terms might well follow next year, to soothe the pain.