Weekly update - ECB: A More Comprehensive Toolkit in the Event of Contagion

The sharp rise in long-term interest rates and the widening of sovereign risk premiums have revived memories of the euro area sovereign debt crisis of the 2010s. However, the current economic environment differs significantly from that period. More importantly, the European Central Bank (ECB) now has a broader range of short- and medium-term tools at its disposal to address a significant tightening of financial conditions within the monetary union. These instruments would allow the ECB to perform the traditional role of a central bank as a lender of last resort, particularly in situations where a government faces difficulties financing itself in the market. Their activation, however, remains conditional in some cases on the implementation of an adjustment programme agreed between the European authorities and the government concerned.

The ECB has short-term tools to limit fragmentation risks. The sharp increase in long-term interest rates and the widening of sovereign spreads have once again placed the ECB’s role in mitigating financial tensions at the center of the debate. At this stage, higher interest rates primarily reflect expectations of stronger euro area growth combined with higher inflation resulting from the energy crisis. Nevertheless, the ECB could implement several measures if it judged that these tensions were disrupting the transmission of monetary policy and spreading across the euro area. In the short term, it could signal a pause in the interest rate hiking cycle it has pursued since June 2026, on the grounds that higher long-term rates are already helping bring inflation back toward the 2% target. The ECB could also temporarily suspend the reduction of its balance sheet under the Public Sector Purchase Programme (PSPP), launched in 2015, and the Pandemic Emergency Purchase Programme (PEPP), introduced during the COVID-19 crisis. Currently, the ECB is reducing its balance sheet at an average pace of €37 billion per month. In addition, under the PEPP framework, the ECB has flexibility in adjusting the pace of its bond purchases and sales. At the onset of the COVID-19 crisis, the ECB purchased proportionally more bonds from peripheral euro area countries than from core countries. It could therefore decide to slow the pace at which it reduces its holdings of a particular country’s bonds.

The ECB also has medium-term instruments. In the event of more severe financial tensions that reintroduce fragmentation risks within the monetary union, the ECB has had additional instruments at its disposal since 2012. First, the ECB may activate the Outright Monetary Transactions (OMT) programme in coordination with European authorities. Under this framework, the ECB can purchase government bonds with maturities of less than three years, provided that the country concerned implements a fiscal adjustment programme coordinated with the European Commission. The ECB may also use the Transmission Protection Instrument (TPI), which allows it to purchase sovereign bonds if it concludes that, following an exogenous shock, the widening of sovereign risk premiums is not justified by the country's macroeconomic fundamentals and/or is spreading to other member states. Finally, these programmes complement the ECB’s various liquidity-providing facilities for the financial sector, such as the Long-Term Refinancing Operations (LTROs). Since their creation, neither the OMT nor the TPI has been activated. However, their mere existence has been associated with a significant reduction in sovereign risk premiums. Although these programmes are subject to conditions, they formalize the ECB’s role as a lender of last resort, not only for the banking system but also for sovereign issuers, thereby helping to reduce the risk of a breakup of the euro area.

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