The European Central Bank has agreed to start talks in early October on reducing its balance sheet, increasing pressure on the already stretched budgets of governments in southern Europe.
Eurozone monetary policymakers met this week in Frankfurt and raised interest rates by 0.75 percentage points to tackle record inflation, but some also wondered how long it would last. could continue to maintain its €5 billion bond portfolio – amassed over the past seven years – at its current size. .
Two people involved in the talks said the ECB would likely decide by the end of the year to reduce the amount of maturing bonds it replaces in a portfolio of mostly government securities it doesn’t. stopped adding until July.
The proposed change, which causes a central bank’s balance sheet to shrink and is known as quantitative tightening, could take effect in the first quarter of 2023, they said.
The ECB said on Friday: “The Governing Council did not discuss the substance or the timing of any future quantitative tightening.”
A change would align the ECB with other major central banks, such as the US Federal Reserve and the Bank of England. The UK and US central banks have already started to shrink their bond holdings as part of their effort to tackle soaring inflation by raising funding costs, leading to accusations that policymakers in Frankfurt lag behind the curve.
The discussion on the ECB’s balance sheet reduction is expected to start at the Governing Council meeting in Cyprus on October 5, when it will not take monetary policy decisions. Any announcement on the matter is unlikely before the end of the year, with the first opportunity presenting itself at the October 27 monetary policy meeting in Frankfurt.
ECB President Christine Lagarde said on Thursday that “now is not the time” to start reducing its bond holdings.
The ECB’s balance sheet – including assets held by national central banks in the euro zone – has fallen from 2.21 billion euros at the end of 2014 to 8.76 billion euros this summer, due to the financial frenzy. buying bonds to fight low inflation and support the economy during the coronavirus pandemic. With inflation now more than four times above the ECB’s target of 9.1%, policymakers have questioned the wisdom of keeping bond portfolios at their current size.
“We have reached a point where the more we add to short-term interest rates, the more inconsistent it seems to us to have the balance sheet where it is and to have the reinvestment program that we have,” said one person involved. in discussions. .
Another person said, “Reinvestments [of maturing bonds] could continue, but they don’t need to equal redemptions, so the balance sheet shrinks.
However, if the ECB reduces the amount of bonds it buys as part of the reinvestments, it is likely to increase long-term borrowing costs for eurozone governments, which have already reached highs of nearly eight years in recent weeks.
The yield on Italian 10-year bonds briefly topped 4% on Friday morning, more than five times higher than a year ago. Rome’s borrowing costs are pushed higher by the ECB’s rate hike, fears over the cost of offsetting the impact of high energy prices on households and businesses and concern regarding potential political volatility after this month’s election.
However, policymakers grew increasingly alarmed by eurozone inflation, which Lagarde called “far too high” above his 2% target.
“The current inflation figure is so out of step with our target that we need to react,” said a person involved in the talks this week. The ECB should continue to raise rates until inflation starts to fall, even if the energy crisis caused by the reduction of gas supplies from Russia pushes the euro zone into recession, the person added. .
Lagarde summed up his more hawkish stance on Thursday, saying raising rates would do little to “convince the big players of this world to cut gas prices” but it would “give a strong signal to people that we are serious and that we will help reduce inflation.” She said it was aimed at “softening demand and guarding against the risk of a persistent rise in inflation expectations.”
Some ECB rate setters worry that long-term rates will stay too low if it continues to buy billions of euros in bonds every month via reinvestments while raising short-term borrowing costs. term by increasing key interest rates.
This creates the risk, they said, of an inverted yield curve in which short-term borrowing costs exceed longer-term ones. Such an outcome would be a problem for eurozone banks that rely on the ability to borrow cheaply at short-term rates than they earn on longer-term loans, such as mortgages.
Next month’s discussions will focus on reducing the amount of reinvestment the ECB makes in the main bond portfolio of 3.26 billion euros it has built up, which is mainly made up of government securities, but also corporate bonds, covered bonds and asset-backed securities.
Reinvestments in this portfolio should amount to 299 billion euros this year, according to Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
The ECB plans to continue reinvesting in a separate €1.7 billion portfolio it acquired under the Pandemic Emergency Purchase Program (PEPP), which it launched in response to the Covid-19 crisis. The central bank said PEPP reinvestments would continue at least until the end of 2024.
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