Eladio Febrero, Jorge Uxó – More than a rate hike: the dangers of Quantitative Tightening

“We believe that by reducing the size of its balance sheet, the ECB’s true purpose is to force Member States to conduct a tighter fiscal policy (besides increasing banks’ profitability).”

Eladio Febrero University of Castilla-La Mancha, Spain

Jorge Uxó Complutense University of Madrid, Spain

Cross-posted from Monetary Policy Institute Blog


Despite the evidence inflation in the Eurozone area is not caused by excess demand, that there are no wage-price spirals, and that specific measures to intervene in the electricity or gas markets, or to make transport cheaper are proving effective in cutting inflation (e.g., in Spain), the ECB raised its key interest rates again on December 15, 2022.

Moreover, in addition to announcing further increases in the coming months, the ECB will reduce the volume of financial assets on its balance sheet, previously acquired for monetary policy purposes, from March onwards. The ECB will stop reinvesting the principal payments from maturing debt (mainly public debt of Eurozone states) at a rate of €15 billion per month. President Lagarde used the word “normalization” twice regarding this Quantitative Tightening process.

This second announcement has received little attention in the media, yet it may have very significant consequences, and we find no convincing arguments for its implementation. Leaving aside the monetarist “justification” (current inflation is the consequence of excess reserves in the past), something unnecessary among the followers of this blog, we shall point out -and refute- three other arguments to try to understand this decision.

First, it could be argued that the ECB has decided to sell part of the government debt that it holds on the asset side of its balance sheet to avoid a loss of capital resulting from the subsequent fall in its price. In this regard, the Financial Times recently warned of the risk to central bank independence of national treasuries (their owners) having to recapitalize the Eurosystem central banks. However, this argument ignores that central banks do not respond with their equity when their liabilities are denominated in legal tender (they can always create additional money) and that they can operate indefinitely with negative capital.

A second argument refers to the increase in the cost of reserves for the ECB resulting from the deposit facility’s higher interest rate. Private banks have vast reserves deposited on the liability side of the Eurosystem central banks’ balance sheets (€4.68 trillion at the end of December, mainly due to the PSPP and PEPP programs). By divesting these assets, the ECB would avoid a considerable cost to central banks (and, by extension, the corresponding treasuries) by simultaneously wiping out these reserves from the monetary system. However, the ECB could avoid incurring this cost by introducing a two-tier remuneration system of bank reserves, as it did in 2019 when the deposit facility rate was negative. At that time, banks only paid the ECB for a portion of the total reserves deposited on their balance sheet, while the rest was exempt, alleviating the effect on private banks’ profits. Something similar could be envisaged today: paying a positive interest rate only on a fraction of total bank reserves, leaving the rest unremunerated. This would avoid a cost to national treasuries amounting to roughly €90 billion that otherwise will go into the banks’ coffers as a windfall profit.

A third argument would rest on the possibility that excess reserves could hinder the purpose of raising interbank rates. The sale of government bonds on its balance sheet would allow the ECB to withdraw the excess reserves in the system. This argument does not hold either: in a “floor rate” system, a central bank has complete control over the interest rate at which it lends reserves to banks, and the deposit facility rate becomes — de facto — the official interest rate.

This being so, we believe that by reducing the size of its balance sheet, the ECB’s true purpose is to force Member States to conduct a tighter fiscal policy (besides increasing banks’ profitability). Proof of this is that three weeks before the announcement of the present interest rate hike, Isabel Schnabel — a member of the ECB Executive Board –stated that the post-pandemic situation[1] requires a restrictive demand policy stance to stabilize inflation expectations at around 2% and avoid second-round effects. To this end, she argued, fiscal policy must be aligned with monetary policy stance, unlike what has been happening until now (most countries are implementing spending increases or taxes cuts). Moreover, she suggested that without fiscal austerity, monetary policy should be more restrictive (“monetary dominance”).

The ECB has sufficient power to do so: with several Member States having a public debt-to-GDP ratio above 100% and not too strong growth prospects, their bond yields are heavily reliant on the ECB’s protection (in fact, following the Quantitative Tightening announcement, in just two days the yield on 10-year Italian and Spanish government debt has risen by 42 and 27 basis points, respectively).

However, we believe this is an error. According to Eurostat, in the third quarter of 2022, half of the Eurozone Member States have not yet recovered the pre-pandemic GDP level (the Eurozone as a whole is only 0.22% above). Further, Italy and Greece have yet to reach the level of late 2008, and Spain has barely surpassed it. Encouraging public investment to expand productive capacity would be more appropriate to fight the potential overheating of the European economy than a restrictive fiscal policy that limits its expansion. Such productive investment should focus on accelerating the energy transition of European economies while strengthening their independence from fossil fuel exporting countries — such as Russia.

With its current policy, the ECB not only adds little value to fight inflation but also hinders the implementation of measures that would be effective and compatible with other economic policy objectives. Conversely, it has the opportunity to take an alternative decision that could provide a substantive boost to the green investment programs that Europe needs: to convert into perpetual debt — or cancel — the public debt it has bought in recent years, relieving the pressure on the States when it comes to refinancing it, as requested by a large number of European economists in 2021 (here).

[1] “[T]he important role of both positive demand-side and negative supply-side shocks in spurring inflation clearly shows that the current macroeconomic environment differs from the one before and during the pandemic, when downside risks to price stability called for an expansion of both monetary and fiscal policy to support risk-sharing and counter weakening demand.” (Here).

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