The ECB Will Likely Act, But Is Still Falling Short

The European Central Bank (ECB) finally seems likely to ease monetary policy later this week, as euro area inflation remains at a basically mandate-defying 0.5 percent [pdf], and the recovery looks increasingly stuck.1 A probable downward revision of its inflation forecast later this week would give the Governing Council an excuse to move. At the same time, the increasingly dovish rhetoric from ECB officials has already been priced in by financial markets. This means that the markets would react negatively to a failure to act, and that it will be harder for Frankfurt to surprise investors. A package of smaller actions is thus likely.

First, Frankfurt is likely to lower the main policy rates by 15 to 20 basis points, bringing the main refinancing rate (MRO, or the rate at which the ECB “sells” short-term liquidity to banks) down to 5 to 10 basis points above zero. The ECB deposit rate (the rate at which the ECB “buys back” excess liquidity from banks) would reach a nominally –15 to –20 basis points. The ECB will surely trumpet such moves as significant, but the direct impact will be limited. Fewer and fewer euro area banks have been using the ECB deposit facility to store excess liquidity overnight. Only €28 billion was deposited on average in May. While banks will likely be indifferent to this step, Frankfurt can hope that the public will be impressed by negative rates and keep inflation expectations steady. The ECB may also signal its willingness to cut the deposit rate further into negative territory, as cash arbitrages (the point at which banks opt to store cash in a vault, despite the costs) only become profitable at rates of –0.5 to –1 percent.

Second, the ECB will likely adopt other liquidity measures to lower short-term real economy interest rates. As a central bank, the ECB deals only with other banks, effectively selling money (liquidity) at the MRO rate and offering to buy it back at the deposit rate. The objective is to make the short-term market price of money charged by banks from each other consistent with the short-term interest rate desired by the ECB. Figure 1 illustrates this case. The thin black line is the daily EONIA (Euro OverNight Index Average) market rate, an effective overnight interest rate computed as a weighted average of all overnight unsecured lending transactions in the interbank market in euros among 35 participating panel banks. Since October 2009, when the euro crisis began, daily EONIA rates have settled between the ECB MRO (red line) and deposit (green line) rates. But EONIA is volatile. Rates tend to spike at the end of each monthly “maintenance period” in which banks’ compliance with regulatory reserve requirements is calculated,2 because banks bid up the price of liquidity to ensure their compliance with minimum reserve requirements. The blue line in figure 1 shows the average EONIA rate for each monthly ECB maintenance period.

The figure also illustrates how the average market EONIA rate (blue line) settles close to the ECB deposit rate in times of uncertainty and ample liquidity when many risk-averse euro area banks store excess liquidity3 with the ECB rather than lend it to each other.

Meanwhile, in times of less uncertainty and less excess liquidity provided by the ECB, the market EONIA rates climb up toward the ECB’s MRO rate. The scale and terms of the ECB’s liquidity provision to euro area banks hence affect short-term market interest rates and banks’ funding costs. Mario Draghi, president of the ECB, has noted that the bank is “particularly attentive” to liquidity provision. The bottom right-hand corner of figure 1 illustrates how the average EONIA rate has settled above the ECB MRO rate for the first time since the beginning of the current ECB maintenance period,4 suggesting uncertainty that a potential interest rate cut will translate into the interbank market and real euro area economy.

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