In a response to a parliamentary question by German MEP Engin Eroglu (Renew Europe, Free Voters), the European Central Bank sheds some light on the risk of interest rate changes for its own bond purchasing programmes.
Eroglu had asked:
“In the case of long-term bonds in particular, rising interest rates go hand in hand with falling yields. The bonds purchased by the ECB are not exempt from this principle. By how much does the value of bonds purchased under the PEPP fall if interest rates rise by, for example, 1% (for the entire yield curve)?”
To this question, the ECB – its President, Christine Lagarde – responded:
“While our monetary policy operations can generate profits, we are prepared to accept financial risks if required to do so in the pursuit of our mandate. (…) We closely monitor and manage the risks on our balance sheet, and assess the adequacy of our financial resources, to ensure that risk-taking is proportionate and necessary with respect to our mandate. (…)
Securities purchased under the pandemic emergency purchase programme (PEPP) and other monetary policy purchase programmes are indeed inherently sensitive to changes in interest rates. The expected relative decline in the market value of a bond portfolio due to a 1% interest rate increase is typically approximated using the weighted effective duration metrics for that portfolio. In the current low interest rate environment, the weighted effective duration of a bond portfolio is very close to its weighted average maturity (WAM). The Eurosystem publishes the WAM of the public sector holdings under the PEPP on the ECB website every two months. The latest published WAM of public sector securities holdings under the PEPP amounts to 7.67 years (end-July 2021). However, the valuation of the Eurosystem’s monetary policy holdings is not directly exposed to short-term fluctuations in interest rates, given that they are valued at amortised cost (subject to impairment), as opposed to being marked to market. This means that their book value gradually moves towards their nominal value as their maturity date approaches and is not influenced by daily changes in market prices. An increase in interest rates would therefore not result in accounting losses for the Eurosystem central banks – neither for the PEPP nor for any other monetary policy purchase programme. (…)
Nonetheless, over the medium to long term, the ECB and the national central banks (NCBs) of the Eurosystem are subject to interest rate risk arising from maturity and yield mismatches between assets and liabilities, which have an impact on net interest income. This risk, however, is not directly linked to any
particular purchase programme, but rather to the structure of the Eurosystem’s balance sheet as a whole. It is monitored closely and assessed over a wide range of interest rate scenarios, including a 1% increase for the entire yield curve as mentioned in your letter. As emphasised above, we are conscious of our financial risk-taking in pursuing our mandate. Let me assure you that the level of interest rate risks to which the Eurosystem is exposed does not pose a threat to its independence.”
Hereby, the ECB admits that its bonds portfolio is “inherently sensitive to changes in interest rates” and could therefore take a hit as a result of increased interest rates. It however stresses that “the valuation of the Eurosystem’s monetary policy holdings is not directly exposed to short-term fluctuations in interest rates”, as a result of its accounting methods. The latter however refers to how to account for losses, not to the fact that increased interest rates may cause losses.
Notably, the ECB also mentions a method to calculate the damage, which it thinks should be done by employing “the weighted effective duration metrics for that portfolio”.
Editor’s note: None of this is any more shocking than the assertion that “water is wet”, but some may find it interesting that the ECB openly admits it, and yet continues with its avid bond buying, relentlessly adding assets vulnerable to increased interest rates to its balance sheet.
#ECB balance sheet hit another ATH as Lagarde keeps printing press rumbling. Total assets rose by €15.2bn to €8,222.7bn on QE. ECB balance sheet now equal to 79.6% of Eurozone GDP vs #Fed's 36.8%, BoE's 38.8%, BoJ's 133.7%. pic.twitter.com/kz69Kg5PKY
— Holger Zschaepitz (@Schuldensuehner) September 14, 2021
— jeroen blokland (@jsblokland) September 16, 2021
Eroglu had also asked a second question:
“Will the ECB become mired in a conflict of interests if the interest rate increases needed to combat inflation lead to massive book losses in the central bank portfolio?”
To this, the ECB responds:
“Regarding your second question on the potential conflict of interest arising if the ECB needs to raise interest rates to combat inflation, let me reiterate that our actions are solely guided by our price stability mandate as laid down in the TFEU. We continue to be fully prepared to accept financial risks if required to do so in the pursuit of our mandate. Profit considerations play no role in determining our monetary policy stance.”
Editor’s note nr. II: Not only may it be more appropriate to discuss “loss” considerations, the question is furthermore whether simply stating that “actions are solely guided by” something can serve as sufficient evidence that they are. In a way, this is more important than central banks officials risking to have a private stake in their policy choices, a topic which just made waves in the U.S. Here, we’re talking about the ECB having an institutional stake in a certain policy option.
— Steve Liesman (@steveliesman) September 17, 2021
"The decline in real interest rates over the last 30 years is not explained well by non-monetary factors but monetary policy seems to play a more significant role" – Claudio Borio (@BIS_org) https://t.co/yUQa4pCEsj
In other words: blame low rates on Central Banks, not on ageing
— Pieter Cleppe (@pietercleppe) September 28, 2018