ECB Balance Sheet To Shrink and Not Return to Pre-2008 Size, Schnabel Says
27 March 2023
By Xavier D’Arcy – FRANKFURT (Econostream) – The European Central Bank should only keep its balance sheet as large as necessary to ensure sufficient liquidity and effectively steer short-term interest rates, Executive Board member Isabel Schnabel said on Monday.
Speaking at Columbia University in New York, Schnabel, who is responsible for the ECB’s market operations, said, ‘[T]he size of our balance sheet should only be as large as necessary to ensure sufficient liquidity provision and effectively steer short-term interest rates towards levels that are consistent with price stability over the medium term’, she said.
‘[T]he size of our balance sheet will not return to the levels seen before the global financial crisis’, she said.
A return to the ECB’s pre-2008 corridor framework was not ‘undesirable or infeasible’ she said, but ‘it may have become more difficult for central banks to correctly anticipate the demand for reserves and hence to steer interest rates in a wide corridor’. She added that ‘such steering would entail a higher operational burden, both for the central bank and the banking system at large, with the need for more frequent fine-tuning operations.’
There were therefore, in her view, ‘two broad options’ for the ECB’s operating framework.
One would be a ‘supply-driven’ floor system, similar to the Federal Reserve, the other would be a ‘demand-driven’ floor system, similar to that recently adopted by the Bank of England.
‘In the Fed’s case you basically have an outright bond portfolio, whereas the Bank of England case you would have a much smaller structural bond portfolio, and the rest would be lending operations’, she said.
As it winds down its balance sheet, the ECB could find that markets rates are more sensitive to excess reserves than in the past, she said: ‘Should the demand for reserves have shifted more fundamentally, then upward pressure on interest rates may well start earlier than estimates of the historical relationship between the level of excess reserves and market rates would suggest.’
If the ECB chooses to follow the Fed’s ‘ample reserves’ framework, it ‘may have to keep a significant buffer of excess reserves in the financial system to avoid unwarranted interest rate volatility’, she said.
The three key interest rates would remain the ECB’s main tools, she said: ‘we see our key policy rates as the main instrument for tightening monetary policy. So that is our primary instrument, which has the strongest impact, or which we hope has the strongest impact on inflation.’
The Governing Council is currently reviewing the Eurosystem’s operational framework and hopes to conclude this process ‘before the end of the year’, she said.
Regarding the ECB’s upcoming monetary policy decisions, she said that ‘we have to see whether the previous baseline that we had in our projections, which was still characterised by upside risks, still holds with all the financial turbulence that we've seen.’
The evidence for the transmission of monetary policy to the real economy was uncertain, in her view. She said it was ‘hard to distinguish whether [the tightening of credit conditions] is related to the energy price shock, or whether it's actually driven by our monetary policy.’
‘If you look for example at the [ECB’s] most recent bank lending survey, if you see what was driving the tightening of credit standards, you see that that banks were saying that was mainly due to a decline in their risk tolerance and an increase in the risk perception and not so much driven by the costs of their funding’, she said.
‘There's no sign of a weakening in the labour market and typically this would be an important transmission mechanism’, she added. ‘If that is not there, you cannot yet see the transmission to prices either.’