By Andreas Charalambous and Omiros Pissarides
Since the financial crisis of 2008, the main central banks have allocated more than $25 trillion to support the global economy. The European Central Bank (ECB) is no exception, having spent more than €5 trillion to acquire bonds as part of its quantitative easing programme, which aimed to address the historically low inflation rates and to restart the economy.
Today, the situation is different: inflation is galloping at levels approaching 10 per cent and the ECB has adjusted its approach by adopting restrictive, stabilising measures. Through 2022, we have witnessed successive rate hikes on both sides of the Atlantic. During 2023, the ECB intends to absorb liquidity through bond sales. More specifically, ECB policy is likely to centre around the following:
Firstly, although inflation has begun to show signs of abating (most prominently in the US, where November was the fifth consecutive month of decline in the national price index), it does remain high. Therefore, within the context of the efforts to further reduce inflation to the long-term desired level of 2 per cent, the ECB has no choice but to continue with its policy of increasing interest rates. It is, however, expected to do so with less intensity, as observed during its recent Governing Council meeting on December 15, when the key rate was raised by 50 basis points, as opposed to 75 basis points that accompanied the previous two rate hikes.
Secondly, interest rate increases have already contributed to an expansion in borrowing costs for European governments. With yields on most ten-year government bonds having risen significantly, it is evident that the support that the expansionary monetary policy has provided to governments for years is running out.
Thirdly, borrowing costs are rising simultaneously, both for businesses and households. At a time when the cost of basic goods, such as energy, fuel and food, has risen significantly, a new wave of loan defaults is likely, adversely affecting banks as well as governments, whose spending towards supporting vulnerable groups continues to expand.
Fourthly, 2023 is a year during which bond issuances in Europe will be at particularly high levels, possibly reaching €400 billion. The cost of issuance will be correspondingly high with important implications. With a view to limit further negative effects, the ECB is expected to proceed initially with a slowdown in reinvestment of maturing bonds, subsequently with a complete cessation of reinvestment, and finally with sales of the bonds in its possession.
Overall, and despite some favourable expectations, including the expected opening of the Chinese economy following the pandemic related restrictions, the new year is predicted to be a year of challenges, given the overall geopolitical backdrop and especially the developments in Ukraine. The ECB’s policy will be of utmost importance for European economies, specifically for the bond markets, should the ECB need to intervene to ensure a smooth functioning of the sovereign debt market for vulnerable economies.
Andreas Charalambous is an economist and former director at the Ministry of Finance. Omiros Pissarides is the Managing Director of PricewaterhouseCoopers Investment Services