The European Central Bank should halve its stock of bonds by mid-2026 before resuming purchases to underpin banks’ lending to the economy, according to a paper by top ECB staff.
After raising interest rates to record highs to bring down inflation, the ECB is reviewing the fate of some 3 trillion euros ($3.27 trillion) worth of bonds it bought over the last decade to stimulate the economy.
The key questions are just how big the ECB’s balance sheet should be now that inflation is no longer too low and what kind of assets should be on it: loans to banks or bonds.
A discussion paper by three of the ECB’s top monetary policy experts found that the ECB should let its stash of bonds shrink to 1.5 trillion euros by the middle of 2026, in a process known as “quantitative tightening” (QT).
The authors estimated this level of reserves, equal to 3.75% of banks’ assets, was sufficient to saturate the banking system, as postulated by U.S. economist Milton Friedman in a celebrated 1969 essay. It is also in line with analyst expectations in an ECB survey.
The ECB would then have to start adding to its stock of bonds again to meet banks’ growing needs for liquidity — in part a legacy of the 2008 financial crisis — so that these don’t curtail lending to the economy, the paper argued.
“We conclude that a neutral QT should run at the expected pace until mid-2026,” authors Carlo Altavilla, Massimo Rostagno and Julian Schumacher said. “Then, the balance sheet should start growing again to finance the secular growth in the demand for central bank liabilities.”
The paper was cited by ECB chief economist Philip Lane earlier this month when he made the case for holding a “structural bond portfolio” to underpin “the willingness of banks to extend credit”.
His thesis is likely to be challenged by other policymakers who would prefer to keep a lean balance sheet and limit the ECB’s presence in financial markets.
FLOOR AND CEILING
Using data from hundreds of lenders and millions of their clients, the paper found that banks extend more credit when they have “non-borrowed reserves”, such as those created by the ECB via bond purchases, than when they have to tap the central bank.
Simulating extreme scenarios, the authors estimated that owning too many bonds would be preferable to getting rid of all them because it would distort lending, inflation and growth by less compared to current expectations.
This may prove a key input for policymakers as they debate whether to continue providing ample reserves to keep a “floor” under the money-market rate, like the Federal Reserve, or have banks borrow at will at a “ceiling” rate, like the Bank of England.
“By our neutrality score, the floor option outperforms the ceiling option as it generates a more moderate loan contraction relative to baseline,” the authors said.
The paper said going back to a pre-crisis setup with scarce reserves and a “wide corridor” between the rate at which the ECB lends and the one it pays on deposits was “utterly unrealistic”.
This is because it would require the central bank to estimate banks’ need for cash at any given time, leading to “systematic miscalculations” and “unnecessary volatility”.
Instead, they advocated a “narrow corridor system” in which banks are permanently supplied with just enough reserves to keep the Euro Short-Term Market Rate (ESTR) equal to the ECB’s rate on deposits, as the market currently expects.
They put this level of reserves at 3.50%-4.0% of banks’ assets and said the ECB should avoid being “particularly parsimonious” to avoid sudden bouts of stress in the money market, as witnessed in the United States in September 2019.
“We view our work, in particular our results on the influence of non-borrowed reserves on bank behaviour, as helpful in calibrating that hybrid system,” Altavilla, Rostagno and Schumacher wrote.
via Reuters
