The European Central Bank has agreed to start discussions in early October on shrinking its balance sheet, increasing the pressure on the already stretched budgets of southern European governments.
Eurozone monetary policymakers met this week in Frankfurt and raised interest rates by 0.75 percentage points to tackle record inflation, but some also questioned how much longer it could continue to maintain its €5tn bond portfolio — amassed over the past seven years — at its current size.
Two people involved in the talks said the ECB was likely to decide by the end of the year to reduce the amount of maturing bonds it replaces in a portfolio of mostly government securities that it only stopped adding to in July.
The proposed shift, which causes a central bank’s balance sheet to shrink and is known as quantitative tightening, may come into force in the first quarter of 2023, they said.
The ECB said on Friday: “The governing council has not discussed either the substance or the timing of any future quantitative tightening.”
A change would bring the ECB into line with other major central banks, such as the US Federal Reserve and Bank of England. Both the UK and US central banks have already started to shrink their bond portfolios as part of their efforts to tackle soaring inflation by pushing up financing costs, leading to accusations that policymakers in Frankfurt remain behind the curve.
The discussion on shrinking the ECB’s balance sheet is due to start at the governing council’s meeting in Cyprus on October 5, when it will not be making monetary policy decisions. Any announcement on the issue is unlikely until later in the year, with the first opportunity coming at the October 27 monetary policy meeting in Frankfurt.
ECB president Christine Lagarde said on Thursday that “now is not the time” to start shrinking its bond holdings.
The ECB’s balance sheet — including assets held by national central banks in the eurozone — expanded from €2.21tn at the end of 2014 to €8.76tn this summer on the back of bond-buying sprees to tackle low inflation and support the economy during the coronavirus pandemic. With inflation now more than four times the ECB’s target at 9.1 per cent, policymakers have questioned the wisdom of maintaining the bond portfolios at their current size.
“We have reached a point where the more we add to short-term interest rates, the more incoherent it looks for us to have the balance sheet where it is and to have the reinvestment programme we have,” said one person involved in the discussions.
Another person said: “Reinvestments [of maturing bonds] could continue but they do not need to be equal to redemptions, so that the balance sheet shrinks.”
However, if the ECB reduces the amount of bonds it buys under reinvestments, it is likely to increase long-term borrowing costs for eurozone governments, which have already shot up close to eight-year highs in recent weeks.
Italy’s 10-year bond yield briefly rose above 4 per cent on Friday morning, more than five times higher than a year ago. Rome’s borrowing costs are being driven up by higher ECB rates, fears about the cost of offsetting the impact of high energy prices on households and companies, and anxiety about potential political volatility after this month’s election.
However, policymakers have become increasingly alarmed over eurozone inflation, which Lagarde described as “far too high” above its 2 per cent goal.
“The current inflation number is so out of whack with our target that we have to react,” said one person involved in this week’s discussions. The ECB is likely to keep raising rates until inflation starts to fall, even if the energy crisis caused by Russia cutting its gas supplies drags the eurozone into recession, the person added.
Lagarde summed up its more hawkish position on Thursday, saying that raising rates would do little to “convince the big players of this world to reduce gas prices” but it would “give a strong signal to people that we are serious and that we will contribute to reducing inflation”. She said it aimed to “dampen demand and guard against the risk of a persistent upward shift in inflation expectations”.
Some ECB rate-setters are concerned that long-term rates will remain too low if it continues to buy billions of euros of bonds each month via reinvestments while pushing up short-term borrowing costs by raising policy rates.
This creates the risk, they said, of an inverted yield curve in which short-term borrowing costs rise above longer-term ones. Such an outcome would be a problem for eurozone banks that rely on being able to borrow more cheaply at short-term rates than they earn on longer-term loans, such as mortgages.
Next month’s talks will focus on reducing the amount of reinvestments the ECB does in the main €3.26tn portfolio of bonds it has built up, which is mostly made up of government securities, but also corporate bonds, covered bonds and asset-backed securities.
Reinvestments in this portfolio are this year set to total €299bn, according to Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
The ECB plans to continue reinvestments in a separate €1.7tn portfolio that it acquired under the pandemic emergency purchase programme (PEPP), which it launched in response to the Covid-19 crisis. The central bank has said PEPP reinvestments would continue until at least the end of 2024.