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Roula Khalaf, editor-in-chief of the FT, selects her favorite stories in this weekly newsletter.
The writer is a former member of the executive board of the European Central Bank and former president of Société Générale.
Long-term rates have risen sharply in recent months in most advanced economies. This caused concern in financial markets, particularly among bondholders, and pushed yields even higher, creating a vicious cycle.
In Europe, the shadows of the 2011-2012 crisis are resurfacing. One of the clearest signs is the widening of spreads between central and peripheral country government bonds, with France this time being treated by the markets as part of the periphery.
In many ways, the European economy is in a very different situation today. The European Central Bank is much better equipped to deal with tensions in financial markets that could endanger the integrity of the single currency. It has bond purchasing tools and programs that respond to spikes in yields.
However, a more difficult aspect for observers and market participants to understand is why, in the current context of tensions, the ECB continues to implement its policy of quantitative tightening, reducing its balance sheet by not replacing assets – particularly government bonds – as they mature. This policy means that a larger share of the net supply of government bonds must be absorbed by private investors, at a time when long-term rates are already under upward pressure.
This policy was launched in March 2023, with the aim of returning the size of the central bank’s balance sheet “to normal” after the expansion of the previous decade. A similar approach was adopted at the time by other central banks. However, other central banks subsequently paused or modified their approach in light of market developments.
This is because the pros and cons of the process by which a central bank reduces its balance sheet may not have been fully considered or openly debated when the decision was made. These deserve careful evaluation.
Kevin Warsh, the new chairman of the Federal Reserve, created a task force led by three prominent economists to do just that for the Fed. In the eurozone, on the other hand, the return to normal has been presented by the central bank as an “obligation”, apparently motivated more by nostalgia for the world before the financial crisis than by rigorous analysis. In fact, there is nothing inherently “normal” about the size of a central bank’s balance sheet, particularly when underlying economic and market conditions change fundamentally over time.
One example of the changes that have occurred since the financial crisis is banking regulation. Financial institutions are now required to hold much larger quantities of high-quality liquid assets, including government bonds, for prudential reasons. This would put further pressure on yields if banks were again forced to obtain liquidity from the central bank by pledging additional collateral.
Another example is the change in the market-making structure of government bonds, with the role of non-bank players such as hedge funds playing a greater role. A consequence of post-financial crisis regulation, this situation exposes markets to tensions when liquidity becomes limited, as illustrated by episodes on the US Treasury market.
Furthermore, a system in which banks must obtain central bank liquidity through refinancing operations at a rate higher than the required reserve remuneration creates a cost for the banking system – which will ultimately be borne by their customers.
It also incentivizes banks to hold larger amounts of government bonds, which defeats the goal of minimizing the bank-state doom loop – where a debt crisis puts pressure on sovereign bonds, in turn destabilizing banks and increasing the risk of a state bailout.
The ECB’s response has been that the pace of its quantitative tightening is relatively slow and that, although the main principles of the new liquidity framework have been defined, the precise timing and calibration of the QT transition remains uncertain. However, this adds further uncertainty and puts further upward pressure on European long-term rates.
In the current environment, where inflation is the main concern, monetary policy should be implemented mainly through its traditional instrument, the short-term policy rate.
Changing the size of the balance sheet should be considered a secondary instrument. This can actually produce unwanted effects that are not yet fully understood. The precautionary principle would therefore suggest suspending QT until a more stable environment is re-established, while taking the time to better understand its implications for financial markets.
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