The Eurosystem reacted – albeit hesitantly – to the rise in inflation rates by realigning its monetary policy. In July 2022, it initially stopped making net purchases of securities as part of the “Asset Purchase Program” (APP) and then began to gradually raise key interest rates. This was followed in December by the announcement that from March 2023 the reinvestment of securities maturing would be reduced in a foreseeable manner. The intention is to reduce the APP portfolio by an average of EUR 15 billion per month by the end of June 2023; the rate of reduction after June 2023 has not yet been determined (European Central Bank, 2023a).
Quantitative Easing (QE) has been replaced with Quantitative Tightening (QT). The Eurosystem is following the lead of the US Fed, which started doing so between 2017 and 2019 but had to suspend tightening during the pandemic. Like the Fed, the Eurosystem does not intend to sell existing holdings of securities in the open market. Instead, part of the investment amounts that are due to expire will not be reinvested, and the Eurosystem will remain active on the securities markets as a buyer. By June 2023, around half of the maturing stocks will be reinvested, meaning that excess liquidity in the banking sector will only decrease slowly. The ECB estimates that this will not be fully reduced until 2029 and that the central bank’s balance sheet will then still be around three times as large as in 2007 (Schnabel, 2023).
Influence on money market control
The Eurosystem justifies its caution with consideration of possible risks for financial stability. Up until 2007, it had attempted to use refinancing operations to provide sufficient liquidity to cover the aggregate need for base money at a money market interest rate equal to the main refinancing rate. This required the central bank to correctly assess banks’ liquidity needs and for liquidity imbalances among commercial banks in the eurozone to be balanced through the interbank market. The ECB does not currently consider either of these to be the case (Schnabel, 2023). It is therefore reluctant to quickly reduce the excess liquidity that has arisen in order to prevent individual banks from running into liquidity difficulties and becoming insolvent. It is considering continuing to maintain a significant “structural” portfolio of securities based on sustainability criteria, and hopes to influence inflation developments by changing key interest rates.
As a result of the liquidity overhang, the interbank interest rate has long been at the lower end of the corridor formed by the top lending rate and the deposit rate (Figure 1).[1] It has now even fallen below the deposit rate because the bottom has “leaked” since a large part of the participants in the interbank market now consists of financial institutions without access to central bank facilities. Under these conditions it is difficult to control the money market interest rate by raising the deposit rate, although the Eurosystem has nevertheless managed to raise the interbank interest rate to just over 3% pa by means of changes in the key interest rate. It remains to be seen whether the combination of a very dovish QT and strong interest rate hikes will be able to slow eurozone inflation.
Interest rate risks as a result of QE
The price the ECB pays for raising interest rates are losses that threaten its independence. As a result of QE, the Eurosystem has become a “debtor central bank” (Schnabl, Schobert, 2009) because its liabilities to the domestic banking sector (under the deposit facility) far exceed its claims (from refinancing operations). The central bank instead holds net claims on governments and non-banks in the form of low-yielding, fixed-rate securities purchased under the asset purchase programs. If the Eurosystem raises the key interest rate, its interest burden increases as a result of the rising deposit rate, without interest income increasing to the same extent, which has a negative impact on the profit for the period.
In the 2022 financial year, the ECB had a net profit of EUR 0 and no distribution of profits to the national central banks (NCBs) of the euro area. Released provisions for financial risks amounting to EUR 1.6 billion are taken into account in this result. The provisions served to cover the losses recorded during the year. These resulted primarily from interest expenses on the ECB’s TARGET 2 net liabilities of around €2.1 billion, as well as write-downs on securities held in its US dollar and own funds portfolios (European Central Bank, 2023b ). The losses from the TARGET 2 balances result from the interest payments that the Eurosystem makes to the commercial banks under the deposit facility and which are booked as liabilities to the national central banks because the ECB does not keep these accounts itself (Siedenbiegel, 2023).
The liquidation that has now taken place has reduced financial risk provisions to €6.6bn, while the ECB’s paid-in capital has increased to €8.9bn as the NCBs reduced their capital shares following the Bank of England’s exit from the ESCB. However, if you take into account that the deposit interest rate has only been positive since September 2022 and has increased several times since then (and will probably continue to increase) and that the balances of commercial banks in the deposit facility amounted to around EUR 3800(!) billion at the end of 2022, the TARGET -2 payments from the ECB continue to increase and will significantly exceed the 2022 figure of EUR 2.1 billion in the next few years. This gives rise to fears that it will not take until 2029 before the ECB’s buffer (currently around EUR 15.5 billion) from provisions and equity is exhausted.
Threat to Independence?
Even if this is a rough estimate that neglects the income from the longer-term refinancing operations (T-LTROs) and possible growing interest income from reinvesting maturing securities, the earnings situation of the ECB should give little reason to be happy in the coming years. It is correct: central banks have to conduct monetary policy according to their mandate, do not work for profit and can fulfill their tasks even with negative equity. Nevertheless, sustained loss reports could increase political pressure on central banks, which will be even more exposed than before to politicians’ desire to meet objectives other than price stability. In order to maintain its independence, the ECB is well advised to let its QE portfolio shrink more quickly and at least not to partially reinvest maturing inventories or to replace the amounts released with new refinancing loans.
literature
European Central Bank (2023a), ECB decides detailed modalities for the reduction of the stocks of the asset purchase program, press release from February 23, 2023, Frankfurt/Main, https://www.bundesbank.de/resource/blob/904254/ab692fe82154fa0742d0340175d0e05d/mL/2023-02-02-app-download.pdf
European Central Bank (2023b), annual financial statements of the ECB for 2022. Press release of February 23, 2023, Frankfurt/Main, https://www.bundesbank.de/resource/blob/905480/1d883fc36a2eb9257e85b21a7dd67090/mL/2023-02-23-annual-statement- download.pdf
Schnabel, I. (2023), Back to Normal? Balance Sheet Size and Interest Rate Control, Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at an event organised by Columbia University and SGH Macro Advisors, New York, 27 March 2023, https://www.ecb.europa.eu /press/key/date/2023/html/ ecb.sp230327_1~fe4adb3e9b.en.html
Schnabl, G., Schobert, F. (2009), Global Asymmetries in Monetary Policy Operations: Debtor Central Banks of the MENA Region, in: The Manchester School, Vol. 77 (1), S. 85-107.
Siedenbiegel, C. (2023), comment: The concerns of the ECB, in: Frankfurter Allgemeine Zeitung of February 23, 2023, https://www.faz.net/aktuell/finanzen/so-stark-hat-der-ezb-das -target-2-system-damaged-18700605.html
[1] Since October 2019, the “Euro short-term rate” (€-STR) has replaced the EONIA as an indicator for the interbank interest rate.
