The European Central Bank is expected to start the delicate process of shrinking its balance sheet this week after eight years of bond purchases and generous lending more than quadrupled its total assets to €8.8tn.
The shift would mark an intensification of the ECB’s efforts to remove monetary stimulus and cool inflation, which in September reached an all-time high of 9.9 per cent in the 19 countries that share Europe’s single currency, almost five times its 2 per cent target.
Policymakers must proceed with caution or risk a UK-style bond market sell-off that would add to the economic problems facing the region. “It is going to be a challenging six months for the ECB, in which many of the potential trade-offs between inflation, growth and financial stability could become more intense and tricky to manage,” said Silvia Ardagna, senior European economist at Barclays.
Thursday’s meeting of the ECB governing council in Frankfurt is set to agree on raising interest rates, almost certainly by 0.75 percentage points for the second consecutive time. That would lift its deposit rate to 1.5 per cent — the highest it has been since January 2009.
Several members of the council, headed by ECB president Christine Lagarde, have said they also plan to discuss ways to start shrinking the balance sheet, which has ballooned over the past decade from around €2tn to a figure that equates with 70 per cent of eurozone gross domestic product.
Markets have grown accustomed to generous support from the ECB. Removing this stimulus when the eurozone is being dragged into recession by an energy crisis and investors are nervous about the high debt levels of southern European countries could be a recipe for financial market turbulence. Giorgia Meloni said in her first parliamentary speech as Italy’s prime minister that tighter monetary policy was “considered by many to be a rash choice” that “creates further difficulties” for heavily indebted member states such as Italy.
A key decision awaiting the ECB this week is how to reduce the attractiveness of €2.1tn in ultra-cheap loans that it provided to commercial lenders after the pandemic hit, known as targeted longer term refinancing operations (TLTRO).
This scheme kept banks lending during the pandemic. But now the ECB is raising rates above zero, it will allow lenders to make €28bn of risk-free profits by simply placing money they borrowed back on deposit with it, according to estimates by US bank Morgan Stanley.
Such a taxpayer-funded boost for banks is politically unpalatable when households and businesses are struggling with rising borrowing costs. An ECB poll of lenders published on Tuesday showed eurozone banks were becoming much pickier in granting loans, pulling back from supplying mortgages at the fastest rate since the 2008 financial crisis.
One option is to change the terms of the loans retrospectively, but banks have warned this could trigger legal challenges and increase risk premia in some countries. Another is to change the rules for remunerating reserves, paying zero interest on TLTRO borrowing. Analysts expect any change to result in early repayment of about €1tn of TLTRO loans in December. The ECB declined to comment.
The central bank could also signal it is preparing to shrink the €5tn portfolio of bonds it has amassed over the past decade.
Reducing the amount of maturing securities it replaces from early next year — a process known as quantitative tightening — would move the ECB closer in line with the US Federal Reserve and the Bank of England. But economists warn shrinking the bond stockpile runs the risk of heightened turmoil.
A sell-off in UK bond markets forced the BoE to intervene last month by restarting its bond purchases temporarily only weeks before it planned to begin selling the large portfolio of gilts it already owns.
Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said the UK sell-off was “a useful reminder that any aggressive withdrawal of liquidity risks being highly disruptive for the bond market and the transmission of monetary policy”.
Given the scars left by the eurozone sovereign debt crisis a decade ago, when spiralling borrowing costs for governments in southern Europe brought the eurozone to the brink of collapse, the ECB intends to tread carefully.
France’s central bank governor François Villeroy de Galhau advocated a careful approach when he told the Financial Times last week: “Balance sheet normalisation shouldn’t be completely on automatic pilot: let us start clearly but cautiously, and then accelerate gradually.”
The ECB bought over €2tn of bonds over the past two years, hoovering up more than all the extra debt issued by eurozone governments in that period. It only stopped enlarging its bond portfolio in July and it continues to buy about €50bn of securities a month to replace those that mature.
Villeroy said he envisaged the ECB would decide on plans to stop reinvestments in its largest pool of bonds — the €3.26tn asset purchase portfolio — as soon as December, with a view to implementing the change during the first half of next year.
The central bank is expected to continue reinvesting a separate €1.7tn pandemic emergency purchase portfolio (PEPP) until 2025 at the earliest. The ECB can focus PEPP reinvestments on certain countries, providing a first line of defence against any severe sell-off in the bond markets of heavily indebted countries.
By building up such a large portfolio of government bonds, the ECB has created a scarcity of highly rated securities, such as German Bunds, which brings down risk-free rates at a time when the ECB is trying to raise them.
Konstantin Veit, portfolio manager at Pimco, said: “As there are limited safe options out there to invest in, this leads to collateral scarcity and drives a large part of the money market to trade well below the ECB’s deposit rate.”
Germany’s debt agency this month sought to address this problem by creating more bonds that it can lend out to investors via repo markets.
