ECB - "We can eat our cake and have it too"
Oddly enough this Seinfeld banter (watched too many reruns I guess) is quite analogous to a hypothetical one between Powell and Lagarde.
The FOMC has acknowledged that the intent of tightening monetary policy to curb inflationary pressures is to tighten financial conditions. It's a desired feature not an unwanted side effect.
ECB on the other hand literally wants to eat its cake and have it too. They have a singular 2% inflation target mandate (as Jean Claude Trichet reminded us often). Even with the new framework where the interpretation of the inflation target is symmetric and has to be achieved on sustainable basis, the ECB much like most other central banks is facing inflation that is materially above its target. With negative deposit rates and large balance sheet, its hardly a debate that policy accommodation needs to be removed.
But with the stagflationary shock of Ukraine war felt most in Europe, the ghosts of Trichet past lurk in the background. The ECB would like to preserve favorable financing conditions i.e. peripheral spreads even as it embarks on its tightening campaign. (“ECB is not the Fed, its not financial conditions but financing conditions" - I digress). There has been a chatter of some sort of facility by the ECB to counter peripheral spread widening should it become disorderly. Now this is where it gets tricky. There are three things to consider -
Legality - QE as a monetary policy instrument has been extremely effective in tightening sovereign spreads. But the charter of the ECB is crystal clear on prohibition of monetary financing.. Lagarde even with her impressive lawyer credentials is unlikely to be able to successfully convince the German Constitutional court that buying bonds to prevent spreads from widening amidst a monetary tightening cycle to fight much above target inflation is somehow justifiable.
Size - Unlimited size is virtually a non-starter given ECB's constraints. This road has been explored before and firmly rejected. To have any sort of tactical but limited program has low chance of success. We have the failures - I mean experience - of Jean Claude Trichet's SMP program to learn from.
Conditionality - So if the facility is indeed necessary and needs to be large enough to be credible - something that OMT program was arguably - it needs to be accompanied with strong conditionality and requires the sovereign to sign a MOU to be triggered. I think its safe to assume this isn't the environment conducive to that.
So where does that leave the ECB. I think they will reluctantly accept that after a decade of handing out candy, its time for some spinach - and you can't really lace the spinach with chocolate sauce to make it palatable. As they unwind years of extraordinary policies that have artificially suppressed interest rates, spreads, term structure and rate volatility, the markets will undergo a period of turbulence till an equilibrium is reached. (First law of Volatility - "Aggregate Market Volatility cannot be permanently destroyed. It can only be transferred from one asset to another or displaced in time dimension.")
However, if they do manage to come up a with creative solution to eat their cake and have it too (and looking at the acronyms of central bank programs over the years there is abundance of creativity), the markets will likely challenge their inflation credibility - with the EUR FX rate, core rates and inflation breakevens reflecting the loss of confidence.
Perhaps Lagarde might then just jump ship to be France's Prime Minister (assuming Macron wins) and let her successor worry about the greedy market speculators.