FRANKFURT — Since large-scale liquidity operations became the norm, markets have become accustomed to treating asset purchases of any sort as a signal that authorities are in monetary easing mode.
But that is set to change.
Central bank liquidity is now in retreat, which means the bigger concern for policymakers is to avoiding overshooting as they drain liquidity, inadvertently prompting wholesale interest rate spikes.
To keep the overall level of reserves in perfect balance with monetary policy, central banks say they need new types of asset portfolios that shouldn’t be confused with quantitative easing policy of old.
These “structural” portfolios will instead operate more like water in a lock, where assets are only bought or sold to keep wholesale rates anchored to the target rate set by monetary policy, which in the ECB’s case is the floor set by its deposit facility.
The permanent level of reserves within the locks should be large enough — but not too large — to keep the overall system afloat, without hindering central bankers’ ability to make continuing adjustments in changing market conditions or unexpected dysfunctions.
Just don’t call it QE
The extremely different nature of these purchases is underlined by the fact ECB hawks, who fought tooth and nail to avoid QE, have voiced no objection in principle. This is because the purchases, or in some cases sales, are aimed at making sure wholesale markets adhere to policy, rather than just setting policy.
In practice, this means that future interventions will not be geared towards making the balance sheet larger. Rather, the portfolio size will grow or shrink in response to market conditions, sometimes even moving in the opposite direction of interest rates.
“The objectives [of QE] were part of a monetary policy to lower medium-term market yields,” Vitor Constancio, former ECB vice-president, told POLITICO. Lower yields made risky assets more attractive creating a more favorable environment for real investment. On the contrary, he explained, “a structural bond portfolio is a much smaller program, trillions lower in fact, not to affect the monetary policy stance, but to manage a regime of ample liquidity in the form of bank reserves.”
Peter Praet, who served alongside Constancio as the ECB’s chief economist, explained that the main reason to keep bond portfolios today is that the structural need for central bank money in the banking system has increased, in particular due to regulation. That implies a bigger central bank balance sheet is needed compared to before the Global Financial Crisis.
“This is generally recognized by hawks and doves,” he told POLITICO.
The rise of permanent bond portfolios goes beyond just the ECB. Over in the U.S., the Federal Reserve looks likely to adopt a similar policy, having confirmed that it will have a much bigger balance sheet than before the GFC even after it ends the current quantitative tightening. At last year’s Jackson Hole Symposium, Stanford University professor Darrell Duffie introduced the idea of “market-function asset purchases”, which should be held in a distinctly disclosed portfolio to avoid the risk of conflation with quantitative easing.
“Central banks should in any case clearly communicate in real time whether their asset purchases have market-functioning or monetary-policy objectives, or both,” the paper said.
An episode already in 2022 showed how easy it might be to misread the new type of asset purchases, when the Bank of England was forced to buy government bonds in the open market to break a vicious circle of selling by leveraged pension funds. This temporary adjustment was misinterpreted by many as a reversion to QE, when the bank’s only intention was to stabilise the key gilt market.
The BoE hasn’t yet committed to operating a structural bond portfolio in the long term, and Deputy Governor Dave Ramsden took pains in a speech two weeks ago to stress that it could run its bond portfolio all the way down to zero. However, the bank’s own analysis suggests it will hit what it calls the ‘Preferred Minimum Range of Reserves’ long before then, leaving it with a substantial stockpile of bonds.
Mix of instruments
The ECB, like the BoE, seems likely to end up using not asset purchases to provide central bank reserves but also short- and long-term loans.
Discussing the ECB’s ongoing review of its operational framework, Eurosystem operations guru Tuomas Välimäki said the mix would help central banks satisfy liquidity demands without losing control of short-term interest rates, while also leaving enough flexibility to respond to changes in the economic or financial environment.
Under the framework, there would be no cap to the amount of liquidity banks could ask for in the credit operations, as long as they have acceptable collateral. Even institutions with limited access to money markets would be able to take part, he explained.
Such a setup, he added, would provide the ECB with valuable information about the level of reserve demand, and in that way help keep its balance sheet as small as possible.
Not too big, not too small
But the ECB still hasn’t decided the optimal size of any such portfolio, or what proportion of overall long-term liquidity it should provide, people familiar with the discussions told POLITICO.
Praet said views still vary widely on the size and composition of the holdings. He, like Dutch central bank governor Klaas Knot, inclines to a small portfolio that minimizes the central bank’s footprint in financial markets. “The appropriate calibration will rather be a process whereby the central bank learns and adjusts to market conditions,” Praet said.
Yet not everyone agrees. Some believe the eurozone economy’s poor performance over the last decade justifies keeping a large portfolio for ongoing stimulus purposes. In a discussion paper published in November, Massimo Rostagno, the director-general of the ECB’s monetary policy department, made the case that a larger portfolio would be more effective at spurring bank lending to the real economy than long-term credit operations.
What there is no doubt about is that bond market interventions will be part of the new normal in Europe and beyond. As one ECB rate-setter put it: “Every modern central bank needs a bond portfolio. It’s not a question of ideology. It’s a question of necessity and practicality.”
