ECB should use bond buys, guidance more cautiously, Schnabel says

FRANKFURT (Reuters) - Interest rate changes should remain the European Central Bank's primary policy instrument and bond purchases, along with forward guidance, need to be used more sparingly, ECB board member Isabel Schnabel said on Thursday.

The ECB bought trillions of euros worth of debt over the past decade in the hope of rekindling inflation and there is still more than 4 trillion euros of bonds left on its balance sheet, impacting market prices years after the need for stimulus has ended.

This market distortion is why the ECB should change its approach to how it buys bonds in a process also known as quantitative easing, Schnabel said, just months before a strategy assessment that looks at how the bank uses its instruments.

"To effectively manage inflation in this environment, central banks need to prioritise agility and flexibility," Schnabel said in a speech in Washington. "Short-term interest rates therefore remain the instrument of choice in most circumstances."

Rates can be changed quickly and years of negative interest rates were undone in a single meeting in mid-2022 when inflation started spiking, Schnabel added.

Similarly, longer-term liquidity facilities to commercial banks are also agile because the ECB can change the terms quickly, so even if liquidity remains in the financial system, terms would change.

Bond buys meanwhile could constrain the ECB for years.

"As bond holdings can be unwound only gradually, asset prices will remain distorted for a long time," Schnabel, a board member in charge of market operations, said. "It means that the bar for starting QE should be higher than in the past."

While the ECB is already running down its balance sheet by letting bonds expire, it could take well into the next decade before enough bonds mature for excess liquidity to shrink to desired levels.

However, bond buys are effective in easing short-term market stress, Schnabel argued.

"Asset purchases are a powerful tool for stabilising financial markets during periods of stress," she said. "Stabilising financial markets typically requires only short-lived interventions."

Forward guidance, a popular tool used during periods of ultra low interest rates, is also problematic because it constrains banks and contributed to the relatively slow initial response to surging inflation in late 2021 and early 2022, Schnabel argued.

"In today’s volatile environment, forward guidance is therefore of limited use to central banks," she argued.