(Bloomberg) -- Market ructions are the immediate worry as the European Central Bank prepares to retreat from €5 trillion ($5.4 trillion) of bond holdings, but the exit is raising more fundamental questions about how it will set interest rates over the coming years.
So-called quantitative tightening, alongside nudging banks into handing back cheap loans, form part of an epic fight with inflation that’s brought the fastest hikes in borrowing costs in ECB history.
But how far officials ultimately push QT will also help determine whether the deposit rate remains their key monetary-policy lever, or whether they revert to closely managing the amount of cash banks have on hand and instead guide borrowing costs through a corridor of interest rates.
A concrete answer could take some time — QT will probably drag on for years. But, with an eye on the experiences of the Federal Reserve and the Bank of England, policymakers are already weighing the options and may offer clues in the months ahead.
The ECB has promised to review how it steers short-term rates by the end of this year — helping decide how much of its bond portfolio may be jettisoned.
Here’s how things stand, what the options are and how the risks look.
The Numbers
The ECB’s largest bond portfolio could shrink by about €210 billion this year if policymakers lift a €15 billion initial cap on reductions that they’ve set for the early months of QT, which kicks off in March.
Decreases will happen as officials simply allow debt to mature, rather than reinvesting the proceeds like they do now. Outright sales aren’t currently envisaged.
QT will come in addition to the €812 billion in low-cost TLTRO loans to banks that will expire in 2023. Lenders also have the opportunity to repay ahead of schedule the €506 billion that mature next year, with the ECB recently adopting stricter loan terms in the hope they’ll do so.
QT and TLTROs could reduce the ECB’s balance sheet to €6.4 trillion by end-2023 from a peak of €8.8 trillion last June.
Extra money washing around in the system, in turn, would be squeezed to about €2.6 trillion — still above levels seen before the pandemic, but close enough to make officials debate how far they want to go and what the knock-on effects would be for monetary policy.
The Present
The ECB currently operates what’s known as a floor system. Its lowest rate — in this case, the deposit rate — establishes a floor for overnight borrowing costs in money markets.
Abundant liquidity means there’s little need nor demand for banks to lend to one another. Instead, they simply park excess cash at the ECB, earning interest at the deposit rate.
Floor systems allow policymakers to guide liquidity and interest rates independently from each other — an important feature when risks of market stress regularly crop up.
At the same time, shortages of the collateral banks need for other financial operations are exacerbated because large amounts of bonds are locked up at the ECB — permanently in a quantitative-easing portfolio or temporarily as securities for programs like TLTROs.
The Past
Before the Great Financial Crisis, the ECB — along with most of the world’s central banks — used a corridor system.
The setup involved tightly managing the amount of money circulating in the financial system — providing cash as needed through weekly auctions and relying on banks to distribute the funds to all corners of the financial system.
The ECB’s main refinancing rate was the starting point for how much banks paid through these auctions. The deposit and marginal-lending facilities acted as the corridor’s floor and ceiling for parking cash and borrowing.
The Future
Maintaining the floor system has its advantages. Excess liquidity makes funding squeezes less likely, while also keeping the ECB in control of overnight borrowing costs.
Reinstating the corridor system has benefits too, though. Collateral would be returned to the market and financial stability may be bolstered as banks would closely scrutinize one another before extending loans. Anyone worried that permanent bond holdings jeopardize ECB independence may also be reassured.
At the same time, a corridor system doesn’t exclude a continued ECB presence in the market, so long as the resulting liquidity is reabsorbed. Policymakers including Executive Board member Isabel Schnabel have floated the option of a larger steady-state balance sheet that could include a portfolio of assets held more or less permanently.
That could cement current strategies like flexibly reinvesting some of the ECB’s maturing debt to calm unwarranted gyrations as rates rise.
The Challenges
It’s all-but impossible to know in advance how much the balance sheet can shrink before the reduction in liquidity sends overnight borrowing costs upward, away from the deposit rate. The risk there is that a miscalculation could throw the entire financial system into a tailspin.
The Fed’s experiences highlight how hard such processes can be. The US central bank began unwinding a $4.5 trillion debt portfolio in 2017 with expectations for a reduction of at least $1 trillion. When Chair Jerome Powell announced in 2019 that rolloffs would end, it was still about $4 trillion.
ECB policymakers must also decide whether bond-market turmoil in pockets of the euro area would halt QT everywhere.
Borrowing costs in Italy, which has the bloc’s biggest debt pile, are more sensitive to signs of political or economic strife, of which — between Prime Minister Giorgia Meloni’s populist government, sky-high inflation and stuttering growth — there’s a lot.
Flexible reinvestments of certain securities through 2024 offer some defense, after which the Transmission Protection Instrument or an older, more punitive bond-buying program may be required. Having the full shield in place for almost the next two years may be one of the biggest incentives to unwind the balance sheet now.
©2023 Bloomberg L.P.
Advertisement