In accumulating massive bond holdings over the course of a decade of quantitative easing (QE), central banks were effectively betting that interest rates would stay low indefinitely. They have lost that wager.
Economists agree: central banks’ bond-buying programs constitute a quasi-fiscal policy, as monetary authorities finance their purchases of long-term government bonds by issuing short-term reserves to commercial banks. Until recently, this seemed to be good business. While the bonds technically yielded little, the cost of financing was so low (-0.5% in the eurozone, for example) that central banks reaped profits anyway.
But with inflation skyrocketing, reaching double-digit rates in many countries, central banks have had little choice but to increase their policy rates rapidly. This has raised the costs of financing, with short-term rates now exceeding long-term bond yields. As a result, the fiscal risks of bond-buying programs are being realized, with central banks facing losses on their holdings.
These losses are unlikely to be fleeting. On the contrary, inflation has become sticky, meaning that central banks will probably have to maintain high interest rates for some time – incurring losses on their portfolios all the while. Because central banks transfer all of their profits or losses to the treasury, these costs will ultimately be borne by taxpayers.
The costs will be massive. The US Federal Reserve has been the most transparent about the scale of the expected losses, revealing that the value of its bond holdings will fall by up to US$670 billion by the end of this year.
The eurozone can expect to incur similar losses. Together, the eurozone’s 19 national central banks and the European Central Bank (EBC) – that is, the eurosystem – hold more than €4.2 trillion (US$4.2 trillion) in government bonds, financed by some €4.3 trillion (nearly 40% of eurozone GDP) in commercial bank deposits. After years of negative rates, the ECB has now increased its deposit rate to 1.5%, and financial markets expect it to reach 3% next year, while the average yield on its bond portfolio is less than 0.5%.
If the deposit rate does increase to the expected 3%, so will the annual cost of holding bonds. Given that the average return on bonds is about 0.5%, an annual loss of 2.5% is to be expected. Multiply that by six years – the weighted average maturity of the bonds held by the eurosystem – and you get a cumulative loss of 15% of the outstanding total, or about €600 billion. That is almost the size of the €750 billion NextGenerationEU programme – the largest stimulus package ever financed in Europe, aimed at advancing the pandemic recovery and the green and digital transitions.
To be fair, one should also account for the profits central banks gained when the deposit rate was negative. But QE still brings net losses – by a wide margin. In recent years, when more than half of today’s portfolio was accumulated, central banks were gaining only about 0.5% on bonds. The difference between the deposit rate and bond yields is now approximately 2.5 percentage points higher (in absolute terms).
Of course, the motives for the bond-buying programmes were never fiscal. Rather, central banks sought to reduce the duration risk faced by the public, with the expectation that this would drive down long-term rates at a time when short-term policy rates were already at the so-called zero lower bound.
It worked, but the duration risk did not disappear. Instead, it merely migrated to the central bank’s balance sheet, and ultimately to that of the government, as the effective duration of government debt was reduced.
In hindsight, it is clear that central banks made a colossal mistake in continuing massive bond-buying programmes over the last few years. Some recognized this at the time, warning that the upside (even lower rates) was limited, and the potential downside (massive portfolio losses if inflation returned) was very large.
Nonetheless, central banks largely ignored their QE operations’ implicit fiscal risks. The ECB, for example, published dozens of research papers (many of very high academic quality) showing the benefits of their bond-buying operations, in terms of higher inflation and employment, without mentioning the potential fiscal consequences.
One hopes that central banks will learn from this mistake. The next time they use unconventional policy instruments with major fiscal implications, they should be far more explicit about the risks – and far more cautious about taking them.
Daniel Gros is a member of the board and a distinguished fellow at the Centre for European Policy Studies.
Copyright: Project Syndicate