Inflation surge puts focus on ECB’s balance sheet

As eurozone inflation soars towards 10 percent, the European Central Bank on Thursday again raised interest rates aggressively to try and bring rising prices under control.

But members of the governing council have started thinking about another lever to bring down inflation: winding down the ECB’s huge balance sheet, swelled by years of anti-crisis measures.

– Why is the ECB’s balance sheet so big? –
Until recently, inflation was for years persistently low in the eurozone.

From the 2008 financial crisis through the coronavirus pandemic in 2020, the ECB stepped in with exceptional measures to prop up the economy.

The policy of quantitative easing initiated in 2015 and the pandemic emergency purchase programme — or “PEPP” — involved the wholesale purchase of government and private debt on the secondary market.

The aim of the two bond-buying programmes was to further suppress interest rates in order to pump up the economy and boost prices.

The Frankfurt-based central bank also unleashed several waves of massive and inexpensive loans to banks, known as TLTROs.

The ECB hoovered up five trillion euros ($4.9 trillion) in debt over the past 10 years and has a stock of around two trillion euros in TLTRO loans in its portfolio, bringing its total balance sheet to around 8.8 trillion euros.

– Why trim the balance sheet? –
The longer the ECB continues to roll over the debt on its balance sheet by purchasing new assets, the longer it keeps the expansionary monetary policy of the last 10 years going.

Increasingly, the sheer scale of the programme seems out of keeping with the ECB’s aggressive moves to raise interest rates in the face of runaway inflation.

The ECB is therefore thinking more concretely about winding down its balance sheet to completely turn the page on the era of ultra-loose monetary policy.

This so-called quantitative tightening would represent the next step in the “normalisation” of the ECB’s policy and “underscore our commitment to ensuring that inflation returns to the (ECB’s) medium-term target of two percent”, according to German central bank president Joachim Nagel.

– How to go about it? –
ECB President Christine Lagarde said in late September that the best tool to fight inflation was still interest rates, which rose by another 75 basis points on Thursday.

Once rates have reached a level considered to be “neutral”, where they neither stimulate nor slow down the economy, the ECB would then look at “how, when, at which rhythm, at which pace we use the other monetary tools that we have available, including quantitative tightening”, Lagarde told a European Parliament committee.

A first step could be to shed the assets built up under the original quantitative easing programme between 2015 and 2021. The ECB has meanwhile committed itself to maintaining the stock of PEPP assets until the end of 2024.

Banks, meanwhile, have been making steady profits by parking the cash with the ECB at new higher interest rates which sit above the interest to be paid on the TLTRO loans.

On Thursday, the ECB tightened the conditions on the most recent tranche of loans, boosting the interest rate paid, and incentivising banks to pay them back sooner.

– Possible problems –
The timing to start tightening is not ideal. It is not clear that other lenders will take the relay from the ECB with their capacity to take more and bigger risks limited by regulations.

The main challenge will be to limit the widening of “spreads” between the borrowing costs for financially stronger and more fragile countries in the eurozone.

It is this fear that motivated the ECB to launch the so-called Transmission Protection Instrument, which would allow the central bank to buy debt from countries whose borrowing costs rise much faster than those of stable benchmark Germany.