The author is a member of the board of directors of the Deutsche Bundesbank
Rising inflation has been a game changer for central banks. A few years ago, when inflation was stubbornly low despite a series of rate cuts, central banks expanded their toolkits to boost inflation. This has resulted in trillions of euros worth of asset purchases. With inflation hitting an all-time high in his 2022 and policy rates rising, it’s time to reverse this extraordinary measure.
The monetary policy purchasing program of the Eurosystem (the European Central Bank and the central banks of 20 member states) stems from an inflationary environment well below the 2% target, coupled with historically low interest rates. Negative side effects were tolerated at the time in order to fulfill the price stability mandate.
The significant market share consequences of our purchase program (about 40% of public debt is in the hands of the Eurosystem) are becoming increasingly visible. The lack of collateral in the market for German government bonds is a significant distortion. The exclusion from traditional investor groups, such as the market for asset-backed securities, represents another side effect. Finally, the important and enduring role of central banks in the corporate and covered bond markets could undermine market liquidity and alienate issuers from traditional investor bases. As a general rule, central banks should intervene in financial markets to the extent necessary for their monetary policy objectives.
We are now facing a different situation than when the Asset Purchase Program (APP) was launched. Excessive inflation requires a decisive response, which the Eurosystem is pursuing. The key policy rate is the primary instrument for guiding monetary policy in that direction. Balance sheet contraction supports this limited path across the yield curve. It’s time for the Eurosystem to scale back its market presence.
The Eurosystem will start reducing its market share by reducing its holdings in the APP portfolio by an average of €15 billion per month between March and June 2023. This represents approximately 50% of the expected redemption value of APP’s holdings at this early stage of its balance sheet. Normalization.
There are good reasons for such a cautious approach from a market functioning perspective. First, financial markets have experienced high volatility and rising yields since early 2022, expanding the risk budgets of many investors in the bond market. Second, the ease of absorbing increased bond issuance will continue to be closely linked to the outlook for inflation and the expected path of interest rates. Finally, the first half of the year is likely to see an oversized share of this year’s bond issuance in the Eurozone hit the market.
By shrinking the balance sheet, we enter the realm of quantitative tightening. There is a lot of theory, but relatively little practical experience available. This is a challenge for central banks and market participants.
Yet there is already mounting evidence that investors are returning to the bond market. Higher yields and coupons are creating incentives and opportunities not only for structural buyers such as insurance companies and pension funds, but also for more price-sensitive investors. Many institutional investors, who have added the least liquid parts of their portfolios (such as real estate and infrastructure) in recent years, may be taking a closer look at their Eurozone fixed income assets again. Additionally, US dollar-based investors in particular enjoy additional incentives to invest in euro assets due to favorable currency hedging mechanisms.
Overall, we are optimistic that the Eurosystem’s predictable and clear withdrawal from holdings of APP will help fight inflation without causing market turmoil. The Eurosystem will reassess the pace and scope of its actions in early summer, so that it can consider a more ambitious future path.
https://www.ft.com/content/9249f729-f3d2-4391-a286-bca85f455576 Eurozone can beat inflation while stabilizing markets