A Plan for Europe’s Great Unwinding

Mario Draghi has less than two years to devise an exit strategy from today’s extraordinary monetary policy.


Mario Draghi, president of the European Central Bank, at a hearing in Brussels, Belgium, Feb. 26.
Mario Draghi, president of the European Central Bank, at a hearing in Brussels, Belgium, Feb. 26. PHOTO: STEPHANIE LECOCQ/EUROPEAN PRESSPHOTO AGENCY/SHUTTERSTOCK

The economic crisis in Europe is finally fading, and Mario Draghi and his colleagues at the European Central Bank can breathe a sigh of relief. Their strategy of negative interest rates and asset purchases is paying dividends. But now the recovery brings fresh headaches for Mr. Draghi. It will soon be time to start the complex task of unwinding the extraordinary and unconventional monetary stimulus that has resuscitated the economy.

The immediate problem facing Mr. Draghi is how to phase out the ECB’s asset-purchase program, known as quantitative easing or QE, and then gradually return interest rates to more normal levels. And that is only the beginning.

The ECB’s balance sheet has doubled in size over the past three years. This is partly as a result of QE. But it is also reflects the €750 billion of cheap fixed-rate, long-term funding that the ECB has lent to banks. In some respects those loans, known as TLTROs, are an indirect form of QE, with the ECB lending the banks cash and the banks buying bonds. Either way the ECB is printing money and its balance sheet is increasing. That balance sheet will eventually have to shrink back to more normal levels.

That will take years. Adding to the complexity, Mr. Draghi’s term as president ends in October 2019. He needs to devise an exit strategy from current ECB policies knowing that he won’t be in charge for much of this process. Although he’ll be keen to signal to investors what to expect from the ECB in the years ahead, there’s no point promising a gradual monetary exit if investors believe his successor will pick up the pace.


Fortunately, there is an option that could simultaneously send a credible signal that interest rates will rise gradually without jeopardizing price stability, wean banks off fixed-rate funding, and acclimate markets to the reality that QE will eventually be reversed. That solution builds on innovations Mr. Draghi has made in the central-bank toolkit. Like all the best central-bank policies, it has an acronym: FG-LTRO, forward-guidance long-term refinancing operations.

The ECB should offer a new round of long-term loans, which would expire in mid-2023, far beyond the expiry of the existing fixed-rate TLTROs in 2021. Banks would be allowed to switch out of their existing loans into these new FG-LTROs but retain the cheap fixed rate of funding they currently enjoy until 2021. After that, the interest rate on these new long-term loans would vary according to the prevailing policy rate set by the ECB.

This new FG-LTRO would have two critical features to set it apart from any normal loan. First, the loan would come with an additional guarantee that the interest rate would never exceed a specified cap. Second, an amortization schedule would be hard-wired into the scheme. Banks would be required to pay back gradually what they owe over the last two years of the loan through regular repayments.

These features would achieve two things. First, the cap on the cost of funding would provide clear guidance to investors, companies and households on how high interest rates can go between now and 2023. Second, the threat posed by the cliff edge in bank funding markets if rates rise unexpectedly quickly would be removed. The abrupt expiry of a huge volume of fixed-rate loans would be replaced with a gradual wind-down of variable-rate loans. Banks would no longer face a sudden spike in their funding costs when the TLTROs expire, which might otherwise have prompted them to scale back their bond portfolios and their loans to households and companies.

For this solution to work, it cannot be too generous, particularly by setting too low a cap on the post-2021 rate. If the FG-LTRO forced the ECB to follow an interest-rate strategy that might turn out to be too lax, it would be a non-starter.

To address this concern, the ECB can calibrate a margin for error into the cap. If you expect the policy rate to rise by about 1.5 points over the lifetime of the FG-LTRO, then the cap could be set at 2 points. There is always the possibility that this might still not be enough. So the ECB also can signal today that any additional tightening can be delivered by allowing the portfolio of asset purchases to shrink, or what is known as quantitative tightening.

One benefit of our plan is that the ECB would take back control of its balance sheet and could credibly signal it is ready, willing and able to start winding down its QE portfolio. The ECB will have that opportunity precisely because the banks will no longer be forced to shrink their bond portfolios when the TLTRO loans expire. Markets otherwise would worry about financial stress if both the ECB and banks were scaling back bond portfolios at the same time.


Mr. Draghi and his successor face a variety of problems in the coming years. The forward-guidance long-term refinancing operation is a way to address many of them.

Mr. Barwell is head of macro research and Mr. Lamy is co-head of aggregate fixed income at BNP Paribas Asset Management.

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