ECB raises rates: risks of Quantitative Tightening from 2023?

Interest rates on main refinancing operations will be raised to 2 percent, interest rates on marginal lending operations to 2.25 percent, and rates on deposits with the central bank to 1.50 percent, effective Nov. 2, 2022.

The Dec. 15 meeting, which will cover macroeconomic forecasts for 2023, will also discuss possible scenarios for reducing the securities portfolio, the dreaded Quantitative Tightening.

But what is Quantitative Tightening? Let's find out together.

To answer this question, we must first take a few steps back in time. Over the past 10 to 15 years, in order to cope with various phases of economic crisis, major central banks such as the U.S. Federal Reserve and the ECB in Europe have adopted a monetary policy that, among insiders, is referred to as "accommodative" or expansionary, with the aim of keeping inflation in the target set by leveraging interest rates in particular.

Indeed, to stimulate the economy, circulate money and push banks to lend more, the ECB and the Fed first lowered interest rates to an all-time low, even below zero.  Then, they injected liquidity into the financial system through a measure called Quantitative Easing ("quantitative easing"-QE) which is the exact opposite of Quantitative Tightening.

Through QEs, central banks put a lot of money into circulation by buying mainly debt securities in the market, especially bonds issued by states or even private companies. In certain historical periods, for example after the crisis of 2008 or the euro crisis of 2012-2013, where there was even a risk of ending up in a spiral of deflation, that is, a general decline in prices caused by economic depression, Quantitative Easing has been helpful in bringing about a reversal of the business cycle.

Under those historical circumstances, the conditions under which QE was decided were very different from those of today. In fact, back then there was very low inflation trending toward zero. Today, prices are rising at rates not seen in decades because of several factors: in America because of a consumption rush and a rise in wages, in Europe mainly because of commodity price increases caused by the war between Russia and Ukraine.

"Quantitative easing (QE) has been the main monetary policy tool over the past 10 years," explains Paolo Baldessari, head of Fixed Income & Alternative Investments at Banca Generali, who adds, "Central banks, grappling with the economic collapse that followed the Great Financial Crisis of 2008, understood that interest rate leverage was insufficient to effectively pursue their objectives."

However, Baldessari goes on to explain, "With inflation back in double digits, central banks have begun to move the traditional leverage of rates again, quickly pushing them into restrictive territory to 'cool' the economy and prices."

Therefore, to halt soaring inflation, the ECB must dilute consumption by raising interest rates and also reducing money in circulation through an unconventional measure such as quantitative tightening.

This tightening of monetary policy, in addition to reducing the amount of liquidity in the market, is expected to drive down the prices of bonds (and consequently raise their yields) since there is no longer a large buyer like the ECB in the market. This change of course also has consequences for sovereign states since they may have to finance their debt at a higher price.

Such a scenario is very "delicate," given the past problems in the Eurozone, which came to the brink of disintegration a decade ago when the ECB was much less interventionist in monetary policy than it is today. Precisely because of the delicacy of the situation, the ECB could use a gradualist approach in implementing quantitative tightening, which analysts expect to begin in mid-2023 while that of the Federal Reserve has already begun.

"It is therefore important for the new government," concludes Banca Generali's head of Fixed Income & Alternative Investments, "to move right away to secure the public accounts, avoiding risky moves that could jeopardize Italy's creditworthiness, which is now one step away from being downgraded to 'junk' status by the major rating agencies, a decision that could drive international investors even further away from our debt."