As the European Central Bank moves forward with raising rates to curb inflation, the debate has begun on reducing its balance sheet, i.e. reducing positions in the bonds it bought under the APP quantitative easing or quantitative tightening (QT) program. . ECB President Christine Lagarde said the process would be taken into account when interest rates “normalize”, which is estimated to start in early 2023 after interest rates hit nearly 2%.

The ECB has bought 5.1 trillion over the last decade. Eurozone Eurobonds, while the value of the APP program portfolio reaches 3.3 trillion. euro, while now it is facing record inflation (10%) and is rapidly gaining momentum in interest rates. The deposit rate is 0.75% from negative just a few months ago, and the central bank is expected to show another aggressive hike at its meeting next week.

As the interest rate is estimated to hit 2% at the end of 2022, APP reinvestment will have to stop, paving the way for the program to be scaled down. Board hawks have recently signaled their focus on the need to cut the ECB’s balance sheet, while Lagarde, speaking at the International Financial Institute’s annual meeting in Washington last week, said that while raising interest rates remains the most appropriate normalization monetary policy tool, stressed that “QT discussions have begun and will continue.”

Dutch central banker Klaas Knott, speaking at an IMF conference, urged the ECB to follow the Fed’s lead by allowing some bonds to expire without being replaced.

Bundesbank President Joachim Nagel said at the same conference that the ECB should push for a “strong” rate hike at its next meeting and start cutting its huge bond positions in 2023 to combat persistently high inflation.

“Quantitative tightening is an inevitable part of the normalization and tightening of policy, but it will not start this year,” said the head of the Slovak central bank, Peter Casimir.

Allow some bonds to expire without being replaced and after interest rates approach 2%.

French central banker François Villeroy de Gallo stressed in a speech in New York that ECB interest rates should reach around 2% by the end of 2022 with a board of directors. to make a sharp increase before adopting a more flexible approach and possibly starting a cautious balance sheet reduction at a later stage and after the repayment of the TLTRO loans. He pointed out that the neutral interest rate, a level that neither stimulates nor slows the economy, is “slightly below 2%” and argued that interest rates above that level are “inconsistent with maintaining a very large balance sheet”.

In any case, the first step for QT is to stop reinvesting in APP and then reduce the ECB’s exposure to the government and corporate bonds it bought under the program. According to reports, the ECB has already laid the groundwork for this and is expected to change the wording of the APP reinvestment rate in a statement at its meeting on Thursday. This means that a more detailed plan will likely be announced at the December or February meetings, with the start of QT pushed back to the second quarter of 2023. apply to Greek bonds with flexible reinvestments lasting until 2024.

The recent turmoil in the UK, which forced the Bank of England to intervene in the market and conduct a temporary QE instead of the planned QT, worries some board members, but everyone agrees that raising interest rates should be a priority. . As Knott noted, bond markets have become more sensitive to debt sustainability issues, and so “a process like QT has to be predictable, it has to be gradual, it has to be even a little boring.”

However, analysts warn that QT could provoke a new crisis in the eurozone. As noted by ING, bond yields have already risen significantly in recent months, and given the very uncertain economic outlook and increased pressure on governments to provide additional fiscal stimulus, QT at the current stage could cause an unreasonable widening of spreads, that is, a new crisis. At the same time, he warns, an early decision on QT could raise the bar for triggering the ECB’s new TPI tool even higher, potentially triggering another crisis. According to Goldman Sachs calculations, QT is expected to boost eurozone core bond yields by 6-11 basis points in 2023 and peripheral bonds by 15-30 basis points, depending on how “aggressive” it is.

For its part, Bank of America points out that QT will force governments to issue bonds and complicate their borrowing strategy plans, while sovereign debt offerings in Europe are already expected (without QT) in 2023. to the level – a record 400 billion euros – against 120-145 billion euros this year.