The ECB meeting last Thursday had been eagerly awaited based on the expectation that the policy rate would be increased and that a tool to address unwarranted sovereign spread widening would be unveiled. This was indeed the case as far as the latter was concerned with the introduction of the Transmission Protection Instrument (TPI), whereas in terms of the interest rate decision, the meeting has brought us into a new era: the deposit rate is no longer negative and forward guidance has been dropped. The comparison of the monetary policy statement of the June and July meetings (see table 1) shows to what extent the message has changed. The intention in June was to raise rates 25 bp in July but eventually the Governing Council went for 50 bp, based on its assessment of the inflation risks and “the reinforced support provided by the TPI for the effective transmission of monetary policy.” This new instrument could be used should spreads react disproportionately to the unexpectedly large hike in the policy rates. In June, the forward guidance was very clear: a further rate increase was expected for the September meeting and possibly a larger increment would be appropriate. Beyond September, “a gradual but sustained path of further increases in interest rates will be appropriate” but this “will depend on the incoming data and how we assess inflation to develop in the medium term.” The new message is that further normalisation of interest rates will be appropriate -which means that rates are still too low- but that further moves will depend on the data and will be decided on a meeting-by-meeting approach[1]. The idea of following a ‘sustained path’ has been dropped, which may reflect unease about how quickly the euro area economy might react to the rate hikes and about the consequences of uncertainty about gas supply during the winter months. In a rising rate environment, forward guidance serves to steer interest rate expectations of market participants. Now that it has been dropped, attention will focus on what would represent a neutral setting: when will rates reach a ‘normal’ level? For the answer to this question, we will have to wait, given  Christine Lagarde’s answer to a journalist’s question: “If you are asking me next ‘What is the neutral setting?’ At this point in time I don’t know.” Admittedly, estimating the neutral policy rate is very challenging, but in the absence of forward guidance, providing a range would be useful as a reference for market participants when forming their expectations.[2]



 The other important decision of the meeting was the introduction of the Transmission Protection Instrument (TPI). Its deployment will be based on a threefold assessment. Firstly, by looking at a range of indicators, whether the evolution of spreads is unwarranted based on country-specific fundamentals. Secondly, whether a jurisdiction is eligible[3] and finally, making a judgment call about the proportionality of the purchases -which are not restricted ex-ante- considering the threat to the transmission of monetary policy. Concerning the eligibility criteria, the Governing Council will take the four categories into account but will decide “in sovereignty in respect to eligibility to the TPI.” The new instrument should allow the Governing Council “to more effectively deliver on its price stability mandate.”[4] What this specifically means has been explained during the press conference: the introduction of TPI made it possible to raise the policy rate more than projected on the occasion of the June meeting. With the introduction of the TPI, the Governing Council now has three instruments to influence the behaviour of sovereign spreads, the other two being the flexible reinvestment of redemptions under the PEPP and Outright Monetary Transactions. Each instrument has its own rationale, as explained in table 2.



Despite the importance of the decisions, the market reaction was short-lived. Bund yields jumped upon the news of a 50 basis points hike but then drifted lower for the remainder of the session (chart 1). Surprisingly, considering the characteristics of the TPI[5], the spread between Italian and German government bonds widened significantly during the press conference but dropped in a second stage (chart 2). The equity market reacted erratically (chart 3), rising on the news of the rate increase, declining during the press conference and rebounding thereafter. Finally and unsurprisingly, the euro jumped on the news of the bigger than expected rate hike, but this movement was short-lived and reminds us of the cyclical environment and risks that are weighing on the euro (chart 4).




To conclude, the data dependency of the pace and size of further rate hikes and the vagueness about the triggers for using the Transmission Protection Instrument (TPI) may lead to an increase of the volatility in interest rates and sovereign spreads whereby investors are trying to understand the ECB’s reaction function. One can also expect two recurring questions during the press conference after the Governing Council meeting: how far are we from the neutral rate and, in case of a spread widening, was it warranted?





[1]the frontloading today of the exit from negative interest rates allows us to make a transition to a meeting-by-meeting approach to our interest rate decisions. Our future policy rate path will continue to be data-dependent”.

[2] In the US, this reference point is provided by the FOMC members’ longer run projection for the federal funds rate.

[3] The criteria include: compliance with the EU fiscal framework, absence of severe macroeconomic imbalances,  fiscal sustainability and complying with the commitments submitted in the recovery and resilience plans for the Recovery and Resilience Facility and with the European Commission’s country-specific recommendations in the fiscal sphere under the European Semester. Source: ECB, The Transmission Protection Instrument, 21 July 2022.

[4] Purchases under the TPI will be conducted in such a way “that they cause no persistent impact on the overall Eurosystem balance sheet and hence on the monetary policy stance.” Source: see footnote 3.

[5] The eligibility criteria do not seem to be very demanding.