ECB’s de Cos: Should Run off APP Portfolio Ony After Sufficient TLTRO Funds Have Been Repaid
16 November 2022
By David Barwick – FRANKFURT (Econostream) – The European Central Bank should start running off the bonds acquired under QE only after markets have absorbed significant TLTRO repayments, Governing Council member Pablo Hernández de Cos said Wednesday.
In a speech at the Conference of the Asociación de Mercados Financieros in Madrid, de Cos, who heads Banco de España, said that reducing the ECB’s balance sheet had effectively begun with the phasing out of TLTRO III operations, and that reducing it further by running off the bond portfolio would best be done only after ‘sufficient outstanding TLTRO III balances have been repaid’.
This, he explained, is because ‘the large TLTRO repayments expected in the first part of 2023 will give us an initial picture of any potential asymmetry and non-linearities in the effects of balance sheet reduction vis-à-vis those generated by balance sheet expansion, by when we will probably have too a clearer idea about whether we are in, or headed towards, a recession’, and because ‘it seems reasonable to wait and observe potential ripple effects of TLTRO III repayments in bond markets before starting the bond portfolio run-off, as it will allow us to assess the effective impact of balance sheet reduction on financial conditions.’
Once these repayments have been digested by markets, full reinvestment of the asset purchase programme (APP) portfolio could end, he said, reminding that the Governing Council intends to decide on the key principles of the reduction of the APP portfolio in December.
Ending APP reinvestments before those of the pandemic emergency purchase programme (PEPP) made sense, he reasoned, because the latter could be needed as long as monetary policy transmission is susceptible to pandemic-related fragmentation, and because this sequence would be more consistent with forward guidance on asset reinvestment.
‘We have clearly stated our intention to continue APP reinvestments for an extended period of time past the date when we started raising the key ECB interest rates’, he said. ‘Moreover, our balance sheet policy will depend too on the operational framework that we adopt for the foreseeable future.’
‘The decision we take in this respect, as well as regarding the desired long-run composition of assets and liabilities, will anchor the desired size of our balance sheet’, he said.
Turning to the question of the possible impact of QT on long-term interest rates, de Cos observed that there was little historical evidence to provide guidance.
‘A number of considerations support a prudent approach, since the response to QT could be stronger than the response to QE’, he said, citing the deterioration of sovereign debt situations recently.
‘The greater the amount of debt that private markets must absorb, the lower the liquidity in sovereign debt markets and the higher the yields that markets will demand in order to equate supply with demand’, he said. ‘Accordingly, this factor tends to magnify the impact of quantitative tightening on the term premium.’
Moreover, the strength of the response to QT might vary with liquidity conditions, he said. Whereas additional liquidity injections under QE had little effect as the market was already flooded, liquidity will be steadily removed under QT, making the market more sensitive to each step.
‘[T]his could mean more volatility in the overnight rate transmitting in the form of more term premium throughout the curve’, he said. ‘Indeed, several episodes in the past have shown these potential effects associated with QT.’
On the other hand, he pointed out, QT is already priced in by markets to a degree, and in general says less than QE about where interest rates are going, as QE and standard policy were linked by forward guidance.
‘In sum, all these arguments point, in my view, to the need for the balance sheet reduction in the euro area to be very gradual and predictable’, he said. ‘It is also essential that balance sheet reductions leave room for action against fragmentation if it reappears, whether either through flexibility in PEPP reinvestments or through activation of the TPI should this prove justified and necessary.’
De Cos noted the ‘substantial progress in withdrawing monetary policy accommodation.’
‘But we are not done yet’, he said. ‘We will need to move rates to levels that allow inflation to converge to our 2% medium-term objective. And for this, we still have some way to go.’
The terminal rate is uncertain, ‘as it is entirely data-dependent and may change over time’, he said. Decisions will consider past moves, the lag time needed for their effect to unfold, inflation prospects and the economy, including ‘the higher probability of a recession that we are currently observing’, he said.