QE Legacy: big losses for Central Banks, big profits for commercial banks

Ben Bernanke one said that the problem with QE is it works in practice, but not in theory.The latter point, much debated in academic circles at the time, centres on the fact that QE was an asset swap -the Central Bank bought bonds, largely Government debt, which paid a fixed interest rate, and paid the commercial bank sellers a floating rate on the reserves created to finance the purchase. So, it was argued, it was a zero sum game, with either side of the swap gaining and losing at any one time depending on the interest rate cycle.

Central banks made large profits for years, because the rates paid on reserves were near zero and in the euro area were negative, falling to -0.5% at one stage. This allowed central banks in may cases to transfer a large portion of these profits to their respective governments.The flip side, for Euro banks in particular, was a big hit to their net interest margin, as they were effectively paying the ECB to deposit money , with reserves swollen by ongoing QE, then augmented by the PEPP operation.

The ECB initially argued that credit growth would offset the negative impact on NIM but eventually became concerned about the impact on banks , eventually introducing a long term loan to banks at a rate below the deposit facility rate (TLTRO III) ,amounting to a profit subsidy.

The onset of the tightening cycle has changed the profit/loss dynamic however. The ECB’s deposit rate, for example, has risen by 4.5%, to 4%, since July 2022, so Central Banks across the zone are now faced with paying out far more in interest than they receive on the bonds they hold, which in some cases carry a negative rate anyway. The Bundesbank’s annual results makes this starkly clear; their interest income in 2023 was €55bn against interest expense of €69bn and with staff costs and other expenses the loss would have been €21.6bn, had they not transferred €19bn from provisions and €2.4bn from reserves. So no transfer of profits to the German Government and another loss is expected this year, which will wipe out the remaining reserves, with losses carried forward until eventually offset by future profits.

The Irish Central Bank has already flagged the probability of losses, particularly as it was making large profits from the sales of its IBRC linked bonds but have now sold the full complement. The Bank still owns €67bn of Irish Government bonds acquired through PEPP and QE, receiving relatively low fixed rates, while currently paying 4% on the €90bn held by Irish banks in the deposit facility( or €3.6bn a year). In some years the Central Bank was transferring €2bn or more from its profits to the Exchequer (not much commented on, oddly enough) but that will be zero this year and no doubt for some time to come .

Why isn’t inflation responding to ECB interest rates?

The ECB’s latest rate increase brought the Deposit rate to 3.25% and the cumulative tightening to 375bp over the past ten months. In addition the Bank has also taken steps to reduce the size of its balance sheet and the degree of excess liquidity it is pumping into the euro banking system and from July will stop reinvesting any proceeds from maturing bonds bought under QE. Yet although headline inflation in the euro area has fallen from a peak of 10.6% to the current 7%, that largely reflects base effects from energy prices, with core inflation at 5.6% and showing no clear signs of easing.

The ECB’s policy actions have had a clear impact on credit and the housing market, both through the effect of higher rates on borrowing costs and via a substantial tightening in credit standards from the banking system-indeed the past six months has seen the sharpest tightening since the financial crisis. Yet although the ECB still expects inflation to fall it is clearly concerned about core inflation and noted in its recent monetary statement that in relation to their rate increases ‘ the lags and strength of transmission to the real economy remain uncertain’.

That uncertainty is highlighted in the ECB’s latest Economic Bulletin in a piece setting out the impact of higher rates as captured across three economic models used by the Bank. In one respect it is reassuring for the Governing Council as it shows that inflation does fall substantially in response to higher rates when using the average effect across the models, with the largest impact in 2024 and 2025. It takes time therefore for monetary policy to work, although the BoE and the Fed tend to highlight lags more than the ECB in policy statements.

However, the models also show a surprising large variation in how rates affect inflation and the real economy, highlighting the uncertainty surrounding monetary policy in the current environment, where inflation has been driven by supply shocks rather than a credit boom and where a high percentage of existing loans in many countries are at fixed rate. One model, for example, shows inflation falling by 0.8% next year, with another showing a much larger 3.5% fall . The latter also shows a 3.5% fall in real GDP in contrast to the former’s 1.75%.

One result of that uncertainty about the impact of monetary policy transmission to inflation is that the ECB appears to be putting far more emphasis on ‘the incoming economic and financial data (and ) the dynamics of underlying inflation’. So the latest inflation data has a big impact on policy rather than any staff projections of inflation in the future. This raises the risks of a policy error (i.e. tightening by too much and causing a large rise in unemployment ) particularly as the bank claims to be both data dependent but with ‘more work to do’ . At the time of writing the market is priced for rates to peak at 3.75% , or another two quarter point increases , but the majority of Council members would want to see clearer signs that core inflation is on a downward path before becoming comfortable with the idea of that rate as the peak.

ECB shreds Forward Guidance playbook and unveils OMT lite

The Covid pandemic prompted a massive fiscal response across the developed world and major central banks unveiled further monetary stimulus, which in the ECB’s case took the form of additional bond purchases (the PEPP) and the provision of long term funding to the banking system on attractive terms (TLTRO III). Central banks as a group were also of the view that the pick up in inflation through 2021 was ‘transitory’ and therefore did not require monetary tightening.

Inflation at the time of the ECB meeting last December was 4.9% and the Bank forecast an average inflation figure of 3.2% for 2022, with a fall back below the 2% target the following year. It did signal that the PEPP would end in March but that its maturing holdings would be reinvested till end-2024 while no end-date was set for its Asset Purchase programme. Reinvestments from the latter would continue for ‘an extended period’ after the first rate increase.

The invasion of Ukraine added further upward pressure on elevated energy prices, notably natural gas, and inflation in Europe and elsewhere consistently surprised to the upside, prompting the ECB to respond in June by signalling rate increases to come, albeit still buying bonds till the end of that month.A quarter point increase in ECB rates was pre-announced for the 21 July meeting, with another rate increase to follow in September, although the latter could be higher depending on the inflation performance. The Governing Council also anticipated ‘that a gradual but sustained path of further increases in interest rates will be appropriate’. The accompanying forecasts projected a gradual fall in inflation to 3.5% next year and 2.1% in 2024, with the decline due to  ‘moderating energy costs, the easing of supply disruptions related to the pandemic and the normalisation of monetary policy’.

Longer term market rates have moved higher in anticipation of monetary tightening , although expectations have been volatile , fuelled by fears of a global recession; 5-year euro swap rates spiked to 2.20% a month ago, from zero in early February, but have fallen back since, declining to 1.5% before a recent rise to 1.75%. Government bond yields have also risen but not in a uniform manner, with Italy in particularly seeing a significant widening in spreads to Germany. The ECB views this as ‘fragmentation’ and promised to announce a policy tool to counter it on top of using PEPP reinvestments in a ‘flexible manner’, meaning using the proceed of an Irish bond maturity, for example, to buy more Italian debt.

Today’s ECB meeting was surprising on a number of fronts. First, President Lagarde announce a 50bp rise in ECB rates instead of the signalled quarter point, citing the recent inflation data and the weakness of the euro. Second, forward guidance on rates has been abandoned, with a ‘meeting-by-meeting approach to interest rate decisions’, meaning that the September rate decision is now open. ‘Further normalisation will be appropriate’ but she refused to be drawn on what a ‘normal rate’ might look like. Gone also was the previous reference to maintaining ‘ optionality… gradualism and flexibility in the conduct of monetary policy’ although one could argue they were mutually exclusive anyway.

The new anti-fragmentation tool duly appeared with yet another acronym – TPI or Transmission Protection Instrument. This has no set limits and can buy public sector debt from 1-10 year maturities ‘to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area’. Eligibility is conditional though on a given country pursuing ‘ sound and sustainable fiscal and macroeconomic policies’ including complying with the European Commission’s country specific recommendations on fiscal policy and recovery and resilience plans for the Recovery and Resilience Facility.

So in effect the ECB is becoming an enforcer of the EU’s fiscal rules, as was indeed envisaged a decade ago with the creation of Outright Monetary Transactions (OMT).. That required strict fiscal surveillance under an ESM adjustment programme and was never actually triggered so this could be considered OMT lite, with the ECB again as fiscal enforcer but with longer maturity purchases ( OMT was out to 3 years).

One area left vague in the TPI announcement was how the ECB will ‘sterilise’ any bond buying to avoid raising its existing bond holdings or adding to the already huge excess liquidity in the system. That detail will be very significant for the market and as yet there has not been a significant reaction in terms of the euro or interest rate expectations.

Can the ECB raise rates aggressively given the Fragmentation risk?

The Euro has a fundamental flaw in that member states have fiscal sovereignty but not monetary sovereignty, which is the exclusive preserve of the ECB. Unlike say the UK or the US, EA governments cannot print money in order to fund fiscal deficits if markets are unwilling to buy that debt. As we saw in 2010, that inability precipitated a full-blown existential crisis for the single currency, which was eventually resolved by a changing of the guard in Frankfurt and Draghi’s ‘whatever it takes’ pledge a decade ago..

That involved the creation of bond buying programme known as Outright Monetary Transactions (OMT) designed to buy the bonds of member states where yields were deemed too high and therefore impairing the full transmission of monetary policy-‘fragmentation’ in the ECB lexicon. Access to OMT was to be at a price though-fiscal discipline, with member state eligibility dependent on fiscal retrenchment.

In the event OMT was never used but in 2015 the ECB embarked on QE, buying the bonds of all member states in an effort to combat the risk of deflation. The ECB now holds €5,000bn in bonds ‘for monetary purposes’, about 41% of EA GDP, including €1,700bn from its PEPP programme introduced in 2020. QE is essentially an enormous Swap transaction, in that the ECB receives fixed interest rate coupons on the bonds it holds while paying a floating rate to banks on their reserves, created by the ECB. That makes the ECB vulnerable as rates rise on those reserves.

The ECB is now faced with an inflation problem, which has accelerated far faster than most expected,consistently exceeding ECB expectations. Indeed, in last week’s staff forecasts, inflation was expected to peak in May at 7.5% but a footnote to the forecast acknowledged that the May figure (released after the forecast cut-off point) had been 8.1%, with the expected average for the year now seem as above 7%.

The Bank has now indicated it will tighten policy by raising rates, starting in July and then September, but had already committed to reinvesting PEPP holdings till end-2024, with the €3,300bn QE holdings also reinvested, this time for an ‘extended period’ after rates had started to rise. So it is still injecting huge liquidity into the monetary system while raising the cost of credit.

The prospect of higher short term interest rates has pushed up longer rates, as one might expect, but not evenly across the EA. German 10 year bonds currently yield 1.60% from -0.40% six months ago, a rise of 200bp, while Italian yields are now up at 4%, having risen by 310bp over the same period. Italian debt amounts to 150% of GDP and so a prolonged period of yields that high, or even higher, alongside limp growth, will push the debt burden up in the absence of much tighter fiscal policy. The latter is difficult politically at the best of times but more so now in the face of calls for much greater support for households struggling with the explosion in energy costs. Ireland seems to be out of the firing line, in that the spread with bunds has only increased by around 25bp, with the yield at 2.30%.

  How will the ECB combat fragmentation? Initially via the PEPP it would seem, with Lagarde emphasising flexibility in reinvesting the existing holdings across jurisdictions. Further, we are told ‘ the ECB will deploy either existing adjusted instruments or new instruments that will be made available’ It’s hard to see what other instruments could mean other than bond purchases (the OMT or an expanded PEPP?) which in effect would amount to intervening when yields have breached some target level. Deciding on that target is another issue of course but would in any case mean the ECB would be trying to control both short term rates and longer term rates.

There is also the issue of legality. The ECJ deemed QE as within the ECB’s mandate but there are fresh challenges to the PEPP, which does not have issuer limits. A clear peak in inflation over the next month or so might help to calm things down but the fragmentation issue raises the question of whether the ECB can tighten aggressively if in doing so it risks triggering another full-blown euro crisis.