As eurozone inflation soars toward 10 percent, the European Central Bank on Thursday aggressively hiked interest rates again to try to rein in rising prices.
But members of the governing council have begun to think of another lever to reduce inflation: liquidating the ECB’s huge balance sheet, bloated by years of anti-crisis measures.
– Why is the ECB’s balance sheet so large? –
Until recently, inflation was persistently low for years in the eurozone.
From the financial crisis of 2008 to the coronavirus pandemic in 2020, the ECB intervened with exceptional measures to prop up the economy.
The quantitative easing policy initiated in 2015 and the pandemic emergency purchase program —or “PEPP”— involved the wholesale purchase of public and private debt in the secondary market.
The goal of the two bond purchase programs was to further reduce interest rates to boost the economy and raise prices.
The Frankfurt-based central bank has also unleashed several waves of cheap, massive lending to banks, known as TLTROs.
The ECB has accumulated €5 trillion ($4.9 trillion) in debt over the last 10 years and has a stock of around €2 trillion in TLTRO loans in its portfolio, bringing its balance sheet total to around €8 .8 billion euros.
– Why cut the balance? –
The longer the ECB continues to roll over debt on its balance sheet by buying new assets, the longer it will maintain the expansionary monetary policy of the last 10 years.
Increasingly, the scale of the program seems out of whack with the ECB’s aggressive moves to raise interest rates in the face of runaway inflation.
Therefore, the ECB is thinking more specifically about reducing its balance sheet in order to completely turn the page on the era of ultra-loose monetary policy.
This so-called quantitative tightening would represent the next step in the “normalisation” of ECB policy and would “underline our commitment to ensuring that inflation returns to the (ECB’s) medium-term target of two percent,” according to the central bank’s president. German. Joaquin Nagel.
– How to do it? –
ECB President Christine Lagarde said in late September that the best tool to fight inflation remained interest rates, which rose another 75 basis points on Thursday.
Once rates have reached a level considered “neutral”, where they neither stimulate nor slow down the economy, the ECB would analyze “how, when, at what rate, at what rate do we use the other monetary tools that we have”. available, including quantitative adjustment,” Lagarde told a European Parliament committee.
A first step could be to get rid of the assets accumulated under the original quantitative easing program between 2015 and 2021. Meanwhile, the ECB has committed to maintaining the stock of PEPP assets until the end of 2024.
Meanwhile, banks have been making steady profits by parking cash with the ECB at new higher interest rates that sit above the interest to be paid on TLTRO loans.
On Thursday, the ECB tightened the conditions of the latest loan tranche, raising the interest rate paid and encouraging banks to pay them back sooner.
– Possible problems –
The time to start tightening is not ideal. It is not clear that other lenders will take over from the ECB with their ability to take more and greater risks limited by regulations.
The main challenge will be to limit the widening of “spreads” between borrowing costs for the financially stronger and more fragile countries in the eurozone.
It is this fear that prompted the ECB to launch the so-called Transmission Protection Instrument, which would allow the central bank to buy debt from countries whose borrowing costs rise much faster than those of stable benchmark Germany.