By Darren Williams
The European Central Bank's (ECB's) reaction function has become increasingly vague, almost deliberately so. But one thing is certain: it will continue to push back against any near-term increase in bond yields.
Last week, the ECB promised faster bond purchases to prevent a premature tightening of financial conditions. This unexpected move sent a strong signal: the central bank is determined to keep euro-area bond yields from rising at a time when US yields are under upward pressure.
Investors Need More Clarity… but Officials Aren't Delivering
The ECB Governing Council (GC) did not, however, specify how many bonds it plans to purchase. And it continued to define financial conditions in a fuzzy and confusing way-although the GC prefers the terms "holistic" and "multifaceted." Indeed, ECB President Lagarde muddied the water further by talking about the "upstream stage" and "downstream aspect" of the monetary-transmission process.
Fortunately, we can cut through some of this obfuscation.
The ECB may prefer a holistic approach to financial conditions, but it's clear that the most important variable to focus on is the risk-free interest rate. In the past, this might have referred to the ECB's refinancing rate; today, it's the whole of the euro-area yield curve-as measured by weighted-average sovereign-bond yields or overnight-index swap rates.
Still, it's unclear whether the ECB thinks about the risk-free interest rate in real or nominal terms-an important distinction that has split the GC. At the heart of this divide is a difference of views over the efficacy of monetary policy.
Members of the GC who think monetary policy can still play an active role in lifting inflation believe that policy is still not loose enough. They argue that higher nominal yields should be resisted even if inflation expectations start to rise (which would lead to lower real yields and a
