British budget debacle helping guide ECB thinking

Bank of England action possible template for nascent euro area quantitative tightening

The debacle over the British government’s now rescinded unfunded tax cuts this autumn has sent ripples through to the European Central Bank. The ECB’s gradual reduction of its bloated balance sheet, starting in 2023, will be strongly influenced by the effects of the financial market turbulence after the UK’s ill-fated 23 September ‘growth plan’.

At its 15 December governing council meeting the ECB is expected to decide to stop full-scale reinvestment of maturing bonds in a section of its €5tn holdings in the first few months of 2023, probably from March or April.

The move will accompany a further rise in ECB interest rates, with the deposit rate expected to rise to 2% from 1.5%. A previously touted 0.75 percentage point rise seems unlikely following more tightening from the US Federal Reserve and announcement on 13 December of a slowdown in annual US inflation.

The ECB will take a cautious line on so-called quantitative tightening. It has been guided by the Bank of England’s relatively smooth progress this year in starting to dismantle its own government bond holdings. These reached a peak of £875bn under UK quantitative easing started in 2009 after the 2007-08 financial upsets.

Joachim Nagel, Bundesbank president, has helped to guide this year’s ECB’s shift to ‘normalise’ monetary policy to counter the unexpected surge in inflation. He has called publicly for all reinvestments of the ECB’s €3.3tn ‘asset purchase programme’ portfolio to be stopped from the first 2023 quarter. However, a probable compromise is likely to lead to a partial stop for full reinvestment, with a complete halt later in the year. Nagel has made clear that any action needs to be done carefully to avoid unsettling financial markets.

The ECB has decided internally that it will make no changes at least until the end of 2023 to its reinvestment of maturing securities under the €1.7tn pandemic emergency purchase programme that started in March 2020. The ECB started QE much later than the BoE. It stopped net purchases of APP bonds at end-June after starting the programme in mid-2014.

The ECB halted net PEPP buying at end-March. It carried on reinvestment to help underpin financial markets and prevent a damaging rise in ‘spreads’ between top-rated German and less favoured Italian government bonds. PEPP reinvestment is scheduled currently to run until end-2024.

Both the political and economic rumpus over the UK’s September measures and also possible liquidity squeezes caused by disruption in crypto markets loom large in European thinking. Officials have been impressed by the Bank of England’s flexibility and resourcefulness in its temporary government bond purchase programme of 28 September-14 October, introduced to help repair the damage of the Truss-Kwarteng ‘mini budget’. Some see this as a possible template for ECB action.

In a speech last month, ‘13 days in October’, Andrew Hauser, the BoE’s executive director for markets, spelled out how the central bank can use its balance sheet to support simultaneously both monetary and financial stability, which attracted attention in Frankfurt.

The ECB is using the clumsy budgetary measures by Liz Truss, former British prime minister, and Kwasi Kwarteng, her chancellor of the exchequer, as an example of how not to run macroeconomic policies. With the ECB having been slow to start tightening, many on the governing council will want to do their bit to avoid a UK-style risk premium for running an overly expansionary (monetary) policy.

Kwarteng’s 23 September budget was labelled ‘fiscal hooliganism’ at the time by a leading European central banker. The measures unleashed scornful amusement from normally tight-lipped economic officials around the world.

The lessons of the episode have been one factor influencing the pragmatic economic policy start of Giorgia Meloni, the new Italian prime minister.

Isabel Schnabel, the German executive board member at the ECB, whose stock has been rising in the last 12 months because of her tilt to greater hawkishness, referred to the British episode last month in a speech in London as a ‘wake up’ call.

The Bank of England decided to stop investing maturing securities in February and started active selling from its portfolio on 1 November. The direct sales (delayed from the earlier plan to start in October) have so far run smoothly. Under the ECB’s favoured step by step approach, no discussion of direct sales from ECB bond portfolios can be expected until 2024 at the earliest.

David Marsh is Chairman of OMFIF.

Join Today

Connect with our membership team

Scroll to Top