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European Central Bank board member Isabel Schnabel urged a more restrained approach to bond purchases, emphasizing that interest rate adjustments should remain the ECB's primary tool for managing inflation. Her comments, delivered Thursday in Washington, signaled a potential shift in the ECB’s approach to monetary policy ahead of a scheduled strategy assessment.
Speaking at a conference, Schnabel highlighted the risks of excessive bond buying, a practice known as quantitative easing (QE). Over the past decade, the ECB has accumulated more than 4 trillion euros in bonds in an effort to boost inflation. However, this strategy has left the ECB with a vast balance sheet that continues to influence market prices long after the initial need for economic stimulus has passed.
"To effectively manage inflation in this environment, central banks need to prioritize agility and flexibility," Schnabel remarked. "Short-term interest rates therefore remain the instrument of choice in most circumstances." Her remarks suggest that the ECB may raise the threshold for initiating future bond purchases, signaling a move toward a more conservative policy stance.
The Challenge of Bond Holdings
Schnabel, responsible for market operations on the ECB’s board, explained that bond holdings cannot be quickly unwound without distorting asset prices. Unlike interest rates, which can be adjusted with relative immediacy, large bond portfolios take years to reduce, meaning their market influence lingers. This delay could hinder the ECB’s ability to respond swiftly to economic changes.
"As bond holdings can be unwound only gradually, asset prices will remain distorted for a long time," Schnabel said. "It means that the bar for starting QE should be higher than in the past."
The ECB has already begun reducing its bond holdings by allowing certain bonds to mature without reinvestment, but this process is expected to stretch well into the next decade. Schnabel’s comments underscore concerns that the bank’s extensive bond portfolio could limit its policy flexibility in the years to come.
Interest Rates and Liquidity Tools Take Center Stage
In her speech, Schnabel pointed to interest rate changes as the ECB’s most effective tool for managing inflation. She cited the rapid reversal of negative interest rates in 2022, following a spike in inflation, as an example of the agility that rates provide compared to bond buys. Additionally, she noted that the ECB’s longer-term lending facilities for commercial banks also allow for quick adjustments in response to changing economic conditions.
Schnabel’s remarks indicate a clear preference for short-term interest rate adjustments and liquidity tools over bond purchases, which she argued should be reserved for specific circumstances, such as easing short-term market stress.
"Asset purchases are a powerful tool for stabilizing financial markets during periods of stress," she said, adding that such interventions should be "short-lived" and not viewed as a standard policy approach.
Rethinking Forward Guidance
Schnabel also expressed skepticism about the ECB’s reliance on forward guidance, a policy tool used to signal future interest rate moves during times of very low rates. She suggested that forward guidance may have hindered the ECB’s initial response to rising inflation in late 2021 and early 2022. In today’s volatile economic landscape, she argued, forward guidance may offer limited utility.
"In today’s volatile environment, forward guidance is therefore of limited use to central banks," Schnabel stated, suggesting that the ECB’s approach should adapt to the current economic climate.
Looking Ahead
Schnabel’s statements come as the ECB prepares for a comprehensive review of its policy tools. With inflation pressures and evolving economic challenges, the central bank faces the task of ensuring its toolkit remains effective and adaptable. Her comments signal that the ECB may place more weight on rate changes and exercise caution with bond purchases and forward guidance in future policy decisions.
As the ECB navigates this transition, financial markets are closely watching for signs of how the central bank plans to balance its vast bond holdings with the need for responsive and flexible policy options in an unpredictable global economy.
