The writer is a former member of the executive board of the European Central Bank and former chair of Société Générale
Long-term rates have been rising sharply over the past few months in most advanced economies. This has triggered concern in financial markets, especially among bondholders, and pushed yields even higher, creating a vicious circle.
In Europe, the shadows of the 2011-12 crisis are emerging again. One of the clearest signs is the widening of spreads between the government bonds of core and peripheral countries, with France being treated by markets as part of the periphery this time.
In many ways, the European economy is in a very different position today. The European Central Bank is much better equipped to address tensions in financial markets that could endanger the integrity of the single currency. It has bond-buying tools and programmes that address spikes in yields.
However, one aspect that is more difficult to understand for observers and market participants is why, in the current stress, the ECB continues to implement its policy of quantitative tightening, the shrinking of its balance sheet by not replacing assets — in particular government bonds — when they mature. This policy means that a larger share of the net supply of government bonds has to be absorbed by private investors, at a time when long-term rates are already under upward pressure.
The policy was launched in March 2023, with a view to bringing the size of the central bank’s balance sheet “back to normal” after the expansion over the previous decade. A similar approach was adopted at the time by other central banks. However, other central banks have subsequently interrupted or modified their approach in light of market developments.
The reason is that the pros and cons of the process through which a central bank shrinks its balance sheet may not have been fully considered and openly debated when the decision was taken. These deserve careful assessment.
Kevin Warsh, the newly appointed Federal Reserve chair, established a task force led by three prominent economists to do just this for the Fed. In the euro area, by contrast, returning to normal has been presented by the central bank as an “obligation”, motivated apparently more by nostalgia for the world that existed before the financial crisis than by rigorous analysis. In fact, there is nothing inherently “normal” about the size of a central bank’s balance sheet, especially when underlying economic and market conditions change in fundamental ways over time.
One example of the changes that have occurred since the financial crisis is banking regulation. Financial institutions are now required to hold much larger amounts of high-quality liquid assets, including government bonds, for prudential reasons. This would put further pressure on yields if banks were again required to obtain liquidity from the central bank by pledging additional collateral.
Another example is the change in the structure of market-making in government bonds with non-banks such as hedge funds taking a greater role. Resulting from post-financial crisis regulation, this exposes markets to stress when liquidity becomes tight, as illustrated by episodes in the US Treasury market.
Furthermore, a system in which banks must obtain central bank liquidity through refinancing operations at a rate above the remuneration of minimum reserves creates a cost for the banking system — which will ultimately be borne by their customers.
It also gives an incentive to banks to hold larger amounts of government bonds, which runs counter to the objective of minimising the bank-sovereign doom loop — where a debt crisis puts pressure on sovereign bonds, in turn destabilising banks and raising the risk of government bailouts.
The ECB’s response has been that the pace of its quantitative tightening is relatively slow and that, while the broad principles of the new liquidity framework have been defined, the precise timing and calibration of the QT transition remain uncertain. This, however, adds additional uncertainty and puts further upward pressure on European long-term rates.
In the current conjuncture, with inflation being the primary concern, monetary policy should be implemented mainly through its traditional instrument, the short-term policy rate.
Changing the size of the balance sheet should be regarded as a secondary instrument. It may actually produce undesirable effects that are not yet fully understood. The principle of prudence would therefore suggest putting QT on hold until a more stable environment has been restored, while taking the time to better understand its implications for financial markets.