What other tools might ECB use?

 

For decade-and-half since 2007, most of the action in terms of euro zone monetary policy was focused on the so-called unconventional policies. First came the liquidity infusions in summer of 2007, which were gradually enhanced and culminated in the switch from fixed allotment to full-allotment policy in the fall of 2008. With the onset of the euro zone sovereign debt crisis then came the asset purchase programs related to the transmission of monetary policy, namely the Securities Market Program and Outright Monetary Transactions program. Finally, the low-inflation period starting in 2014 lead to introduction negative deposit rates and targeted long-term refinancing operations (TLTROs), and culminated in systematic asset purchases under the Asset Purchase Program.

For now, the shift to normalization of monetary policy also meant shift away from unconventional and back to normal policy instruments: the interest rates. After the asset purchases have been discontinued in first half of this year, and TLTROs are no longer expanded, the central bank started raising all it policy rates. Already the first hike ended the 8-year long policy of negative rates, and by the end of this year the policy rates will in all likelihood be approaching something what can be considered normal or neutral levels.

However, this does not mean that the other policy instruments will not be tampered with. Indeed, there are reasons to believe that the central bank will take steps that will reverse some of the unconventional moves taken in the past, some of which will have potentially important implications for monetary policy stance. True, any change in strategy regarding the stock of assets purchased during last 10 years is unlikely in the near term. Instead, the central bank might take two actions that were not part of the usual tightening cycles before the Global financial crisis: It might make asymmetric moves in policy rates, and it might take step that will directly or indirectly alter the renumeration of excess reserves.  

Spreading the policy spread

Before the Global financial crisis the world of central bank policy rates was pretty simple. There was the main refinancing rate (MRR), at which bank could borrow from the ECB during the regular tenders. It was the main policy rate influencing market interest rates, hence its name. The other two policy rates – the deposit rate (DR) and the lending rate – were 1 percentage point above and below the MRR, respectively, and always moved in lock-step with the MRR.

This all changed in the following years. First, in the world of excess reserves, which emerged in 2008 and remained with us since, the MRR was no longer the “main” rate, since the deposit rate became by far more important for market interest rates. So much so, that by now the MRR is almost irrelevant and all the focus is on DR. Second, from 2013 the spread between MRR and DR was no longer the fixed one percentage point, but rather the central bank started changing rates asymmetrically. First, the spread between the two was decreased in 2013 and 2014, reaching low of 0.25%, and then it was increased again, reaching high of 0.5%.

During its first hike in July the ECB moved all rates in lock step, mostly in order to keep things simple. However, this does not mean that the central bank cannot change the spread between the two rates, and there are reasons to think it might. For example, during one of the fall meetings it could increase the MRR more than the DR, in order to increase the spread back to the presumed desired long-term level of 1 percentage point. This would have the additional advantage that the bank could portray this as step up in the inflation fight. Importantly, in reality this would not amount to significantly faster tightening  of financing conditions. Indeed, it would virtually not amount to any tightening at all, much like cuts in MRR in 2013 did not amount to any easing as far as market rates are concerned. Hence, it would be a PR victory without any real costs. This could even play well with the dynamic inside the governing council, as the doves could use it as a concession to the hawks without worrying about undue impact on the economy. This reasoning suggests to us that we are likely to see such move during one of the upcoming meetings.

Ever heard of negative re-numeration?

The other unusual move we are quite likely to see is a change in renumeration of excess reserves, something the bank has already hinted in its July meeting. However, in this case the situation is much more complicated fraught with risks, and the motivation here is purely in terms of political optics.

Up until now, the central bank was renumerating any excess balances with the deposit rate. Prior to Global financial crisis this renumeration amounted to almost nothing, given that banks faced powerful incentives to not hold any excess reserves. Afterwards, when the deposit rate went to zero there was no renumeration whatsoever.

When the ECB moved to negative rates, it turned the renumeration principle on its head: Rather than paying commercial banks when they had excess reserves, it started charging them, by making the deposit rate negative (and shutting down avenues to avoid this). This was combined with large-scale asset purchases under the Asset Purchase Program, which resulted in large amount of excess reserves being infused into the system. As a result, the ECB was pocketing huge profits: not only was the bank earning interest on its assets, at least as long as those remained positive, which on average they did. But it was also pocketing huge sums thanks to its liabilities being “renumerated” with negative interest rate. It is as if you borrowed money from a friend, invested them at profit, and yet your friend would be paying you for lending you money.

This was putting a strain on the profits of commercial banks, which is why the central bank introduced tiering of excess reserves renumeration in fall 2019, when it restarted asset purchases. This way, it kept the pass-through from deposit rate to market rates intact, while not raising worries about commercial banks solvency.

Re-labeling excess as required

Of course, this is all going to change when deposit rate rises above 0%. This will mean that the ECB will be paying money to commercial banks, rather than receiving money. With excess reserves standing at 4 trillion, this would amount to tens of billions of euros as soon as deposit rate would rise significantly above 0%. Unsurprisingly, the central bank is thinking about how to avoid this. Not only it would hit its profit, turning it from positive to negative. More importantly, it would amount to very bad politics: The headlines would be full of stories about commercial banks getting money from the central bank, something very unpleasant in normal times, and much less so when everybody is undergoing unprecedented cost-of-living crisis.

The problem is how to go about this. Consider first the option of raising MRR without raising DR. While this sounds great in theory, in practice it would defeat the goal of raising market interest rates, which now respond only to movements in DR. So this is not an option in so far as the ECB wants to tighten policy stance. This leaves as an alternative avenue only two options: changing the amount of excess reserves by re-labeling them as required reserves, or changing how excess reserves are renumerated.

Start with the first option. The central bank could easily just say that banks are suddenly required to hold much higher level of reserves by changing what is called the reserve-requirement ratio. This currently stands at 1%, meaning that bank needs to have reserves equal to 1% of its deposits. Changing this ratio is not unheard of. It used to be an active policy tool in western world in the last century, and the emerging markets central banks, such as central bank  of China uses is to this day.

There are problems with this approach, though. First, increasing the reserve ratio would mean that the market interest rates would move away from the deposit rate. Since as the amount of excess reserves would decrease, and since the spread between money market rates and deposit rates is negatively related to amount of excess reserve, this would lead to an increase in this spread. Hence, this step would amount to tightening of monetary policy stance. Moreover, this tightening would be hard to calibrate, and the central bank could easily overdo things. This is especially true given that the increase in reserve ratio would be very large for it to have meaningful impact of ECB profits.

However, potentially more important than this average effect would be the distributional effect. The excess reserves are not distribute among banks equally, so increasing the reserve ratio would cause some banks suddenly to be short of reserves, leading them to need to borrow reserves from banks that still have excess.

What is the problem with this, given that this was normal before the Global financial crisis? Mainly, that we are in a very different world already for more than a decade. Ever since the Global financial crisis banks became unwilling to lend to other banks out of fears about solvency. Moreover, as amount of excess reserves increased, there was a less and less need for banks to borrow. Hence, effectively there hasn’t been any lending/borrowing of reserves on significant scale for more than a decade, and it is far from clear how would banks respond if the need arose.

This is especially problematic because the banks with lower reserves are likely geographically concentrated in the euro zone periphery. Putting pressure on these banks could quickly lead to re-emergence of fragmentation in the monetary union, something the central bank is desperate to avoid. It could even spill into the bond markets, as periphery banks could try to sell their bond holdings to raise their reserves.

So overall, it is fairly unlikely that the ECB would choose this as its main approach. This, however, does not mean that the bank would not use this approach on the margin. An obvious step would be for the bank to increase the reserve requirement ratio at least to 2%, where it stood prior to 2012, but possibly more, say mid-single digit levels.

De-numerating the re-numeration

This leaves the other approach of changing how excess reserves are renumerated. There is a clear precedence for this in the tiering introduced in 2019. At that time the ECB followed the Bank of Japan and allowed part of the excess reserves to be renumerated by 0%, rather than the negative deposit rate. Like that the ECB lowered the total amount commercial banks had to pay to it without changing the marginal rate, i.e. the rate that applied to the last euro of excess reserves. This meant that the effect on market interest rates was almost nil.

The central bank could put this logic on its head. Rather than allowing balances below certain threshold to be renumerated by 0%, it could mandate that balances below some threshold would be renumerated by 0%. While this sounds almost identical, the difference is that while before it was 0% instead of negative deposit rate, now it would be 0% instead of positive deposit rate.

What would be the implications of this move? To see this, consider situation of two commercial banks - one with excess reserves below the threshold and one with excess reserves above - when deposit rates were negative.  The one with excess reserves below threshold was paying zero interest on its reserves, while the other one was paying interest on balances above the threshold. In this situation the bank with lot of excess reserves had incentives to lend them to the other bank, and thus lower its bill.[1] The other bank meanwhile was willing to do that because it would still pay zero, as long as it stayed below its threshold. This dynamic had the added advantage from the perspective of the ECB, since it shifted reserves from banks in the core to banks in the periphery, a desirable change in fragmented monetary union fighting low inflation.

Now consider the same situation when deposit rates are positive. The commercial bank with excess reserves below threshold would be earning zero interest on its reserves, while the other one would be earning reserves on balances above the threshold. This is the flip side of the situation we observed before, but this time it creates incentives that are also reversed. Rather than pushing reserves from banks with high balances to banks with low balances, this time around it would create incentive for excess reserves to be pushed towards banks with high balances.

The banks with high excess reserves would have incentive to borrow from banks with low excess reserves as long as the transaction rate would be below deposit rate. Meanwhile, the banks with low excess reserves would have always incentive to lend, since earning positive interest is better than earning 0%.  Indeed, banks below threshold should be willing the lend all of their excess reserves to other banks, and keep only the amount required, while banks above threshold should be always willing to borrow.[2] And this is a potential major flaw of this design, because it would cause bifurcation of distribution excess reserves, with some banks holding large amounts and some banks holding zero. While before there was a stable equilibrium where all banks were close or above their threshold, this time the equilibrium is unstable. Any bank that drops below threshold would have incentive to decrease, and any bank that jumps above threshold should be willing to increase.[3]^,[4]

What about the aggregate effects on market rates? In world of negative deposit rate the effect of tiering on market rates was almost nil, since there remained incentive for reserves to be lent out at rates close to the deposit rate, with banks with low reserves borrowing from banks with high reserves. This kept market rates anchored by deposit rate. This logic would still remain true, as banks above threshold would have incentive to borrow as long as transaction rates would remain below deposit rate, and competition over available excess reserves would ensure that market rates would still remain anchored to deposit rate.[5] As the deposit rate would rise, the market interest rates would follow. That said, the anchoring would be from below, potentially significantly so, and hence from perspective of market interest rates this would amount to easing of policy stance.

Therefore, the distributional effects are clearly problematic - especially in currency union where these redistribution effects are not irrelevant -while the aggregate effects are not. Where does this leave the ECB? In principle, it could ignore the problematic distributional effects in order to achieve its mostly political objective. In practice, the ECB would likely try to have its cake and eat it too. It could do this in two different ways. First, it could set the threshold so low that most banks would remain above, so that almost no banks would have real incentive to de-accumulate excess reserves. Or it could set another threshold over which excess reserves would not be renumerated, so that there would be only a band in which full renumeration would apply. However, to make sure that this would not prevent market rates being anchored by deposit rate, it would have the remain the case that at any given time there are is significant number of banks withing this range.

In either case, the discussion shows that this approach is  fraught with calibration issues, which means that we would not be surprised by the central bank avoiding this minefield altogether. That said, some action is clearly going to occur, the question is how significant it will be.

Not rocking the boat full of bonds

What about ECB’s assets? In contrast to asymmetric changes in policy rates and changes to renumeration of excess reserves, we are not likely to see any activity on the front of the stock of asset purchased in last decade. This is despite the fact that the one option the ECB has in this regard - letting the portfolio mature without re-investments over time – would help with the problem of paying banks large sums.

The motivation is clear here. The normalization of policy rates is already making bond markets skittish, sending fear up the spine of the ECB. This creates very powerful incentive for the bank to avoid rocking this boat any further. Indeed for now the ECB is using re-investments from the Pandemic Emergency Purchase Program as first line of defense against volatility in bond markets by selectively re-investing the proceeds into periphery government bonds. There is little reason the central bank would want to give up this nimble tool and instead add to the fire ending these re-investments. For these reasons, no action on this front is on horizon.

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[1] More true description of reality is probably focusing on other avenue of changing amount of excess reserves, namely buying assets, rather than lending out excess reserves. When commercial bank buys an asset from another commercial bank, it pays it in form of its reserve balances, what then achieves the same outcome of redistributing excess reserves from one bank to another.

[2] Again, more likely avenue through which this would operate would be via asset purchases/sales, see previous footnote. Bank with excess reserves below the threshold has opportunity cost of excess reserves equal to 0%. In contrast, bank with excess reserves above threshold has opportunity cost of money equal to (now positive) deposit rate. Hence the first bank should be more eager to buy assets than the second bank, leading the first bank to (indirectly) buy assets from the second bank, which would eventually lead to the same redistribution of excess reserves as lending between the banks. Note that while in world of negative deposit rates the incentives were for the banks in the euro zone core that were rich in excess reserves to buy assets, this time it would be the banks in periphery that would have incentives to buy assets. This might be undesirable.

[3] Of course, bank just below the threshold might decide to make the decision to go increase its reserves just above the threshold. That said, since this is uneconomical – it needs to accumulate some reserves for which it gets 0% interest, rather then lending them out at above 0% interest – it would apply only to banks close to the threshold.

[4] Note that in practice, there would be other limits to this behavior. The lending banks would face limits imposed by credit-risk rules, which limit how much exposure to single entity should bank have. The borrowing banks might face limits with respect to their size, either in form of liability-to-equity ratio. But the general tendency would hold.

[5] This is the situation in the U.S. where some financial institutions have access to the deposit facility, while others do not.