Dwindling ECB reserves could cut rates needed to stabilize inflation

Dwindling ECB reserves are pushing up interest rates on sovereign debt and reducing lending to businesses and households, thereby potentially lowering the level of rates needed to stabilize inflation.

ECB Chief Economist Philip R. Lane predicted this Thursday at the opening of the ECB’s 2023 money markets conference that further drawdowns in reserves in the coming years “will put upward pressure on sovereign debt rates and contribute to a tightening of lending.” .

The ECB’s reserves are now falling because the ECB is no longer reinvesting the bonds it purchased under its first major bond purchase program and because banks are repaying ECB debt early.

Lane expects the ECB’s current reduction in the bond market presence and the return of the very cheap liquidity it has been lending to banks for three years to continue in the coming years and therefore there will also be upward pressure on sovereign debt rates and credit contraction. Creation.

According to Lane, these forces could reduce the level of interest rates needed to stabilize inflation as they lower growth rates and inflation expectations.

“Of course, the full effect of the decline in central bank reserves depends on the endpoint of this adjustment process, which depends on the future sustainable level of central bank reserves,” Lane said.

The ECB’s chief economist said he expects the adequate level of reserves to be “much higher and more volatile in this new steady state compared with the relatively low levels that prevailed before the global financial crisis.”

For banks, ECB reserves are a liquid and risk-free asset, which is very important in times of crisis, such as the global financial crisis, the sovereign debt crisis and the pandemic.

These episodes underscored the importance of banks maintaining significant levels of liquidity.

In the euro’s first decade, ECB reserves were much lower because the ECB created reserves only to “meet liquidity needs arising from demand for banknotes and so-called autonomous liquidity factors,” Lane said.

These are liquidity factors that do not normally arise from the use of monetary policy instruments and include, for example, banknotes in circulation, government deposits at the central bank and the ECB’s own funds.

After the onset of the financial crisis, the ECB began lending to banks for more than a year and purchased some bonds on a limited basis between 2008 and 2013, which moderately increased its reserves.

But from 2015 to 2022 there was a sharper increase in the ECB’s liquidity through quantitative easing with the purchase of large amounts of debt and liquidity operations and, as a result, its reserves increased.

According to Philip R. Lane, the ECB has reduced its reserves since autumn 2022 and will reduce them further in the coming years.