When we look at the balance sheet of the State and the Central Bank as a whole, we realise that Quantitative Easing has the potential to transform fixed-rate government debt into floating-rate debt. This is a possibility that was very positive in the months prior to the rise in inflation, as it widened the space available for fiscal policy. Today, however, QE is becoming problematic as central banks tighten monetary policy.
So what happens when inflation returns? Under normal circumstances, the increase in market interest rates reacting to central bank signals only applies to government refinancing flows, with a very gradual impact on public resources. Therefore, switching to floating rates brings more “pain” when interest rates rise. This is true for households and firms, and also for governments.
However, it is true that, in principle, the ECB could simply ignore the cost of persistent excess reserves. Theoretically, there is nothing to prevent a central bank from operating with an impaired capital position or even negative equity. However, in the real world, there are at least three issues that a central bank must consider. First, financial losses, even “paper” losses, which could alter public confidence in the institution. Second, an independent central bank will always be reluctant to go “cap in hand” by asking for a recapitalisation of its shareholders. Third, paying billions of euros to banks to maintain the safest possible form of liquidity may generate public criticism as a manifestation of undue support for the banking industry at a time when rising interest rates should, in any case, raise their margins.
There are two main, but not mutually exclusive, mechanisms for the central bank to manage the problem. On the one hand, it can act on the amount of excess reserves by “absorbing” QE, first by ceasing to reinvest maturing bonds and then more aggressively by selling those it holds in the market, which has come to be called Quantitative Tightening. Or it can change the conditions for remuneration of reserves, for example by lowering the deposit rate to zero above a certain holding threshold.
The latter is the most attractive in the case of the ECB, but accelerating quantitative tightening (QT) could lead to an excessive tightening of financial conditions: its impact is much more difficult for the central bank to gauge than a “classical” increase in the key policy rate. Given the current uncertainty in financial markets, it is likely that the ECB will choose to proceed carefully, first by gradually reducing the size of reinvestments and eventually by selling the remaining capital. In any case, in the QE part of the Pandemic Emergency Purchase Programme (PEPP), the central bank has already committed to wait until the end of 2024 at the earliest.
From a macroeconomic impact point of view, reducing the remuneration of excess reserves may go in the opposite direction of QT, as it would push banks to redirect their allocation towards risky assets. There too, the ECB is likely to want to tread carefully and position the threshold beyond which excess reserves are no longer remunerated too much.
Finally, it should be noted that, technically, there is at least one other option. The ECB could “mop up” excess liquidity by issuing its own securities: ECB bills. In essence, this would be the same as bank notes (the most intuitive form of central bank liability), but such an introduction would require careful planning, in particular to gauge the competitive impact it might have on the bond market. Therefore, we do not believe that this would be feasible as an answer to the current and urgent problem.
