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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 [ZIP]. 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.

As a result, it seems probable that the ECB will try to provide additional liquidity to the euro area banks to try to push market EONIA rates down as much as possible and certainly below their recent level above the MRO level and possibly beyond what the 15 to 20 basis point rate cut would immediately translate into and potentially even into slight negative territory, too. There are two main ways in which the ECB could easy provide such additional liquidity.
First, it could stop sterilizing the €165 billion in liquidity provided by the earlier interventions through the Securities Market Program (SMP), which is now closed. Such a step would more than double the €110 billion in excess liquidity available during May 2014 and push excess liquidity up to about €270 billion, a level it last reached in 2013, when the EONIA rate settled at close to the zero deposit rate of below 0.1 percent (see figure 1).

Second, the ECB could offer euro area banks another special term refinancing operation (STRO5) with a very long maturity and fixed (low) rate. This step would replicate the ECB's operation in late 2012 and early 2013 of a 3-year STRO, which dramatically increased excess liquidity in the euro area. It seems unlikely that a new STRO could reach a scale similar to these two. But a new fixed-rate STRO in excess of 3 years would probably interest euro area banks enough to take the money and could stimulate the economy more than any forward guidance. This would be achieved by euro area banks securing—and passing on to real economy borrowers through new fixed rate loans—3y+ of the current very low interest rates, much longer than the ECB can credibly offer to keep short-term rates low.

Given EONIA's recent rise above the MRO rate, the ECB is almost certain to stop sterilization of the SMP. An additional STRO is also a high probability.
The ECB might further surprise observers by committing itself to another limited asset purchase program for specific private sector assets—packaged bank loans/asset-backed securities or more bank bonds. If such an unlikely step were to be taken, it would occur after the asset quality review/stress test results are announced in October. This would be a sort of forward guidance on "future nonstandard measures," just like the ECB now promises to keep interest rates low for a prolonged period. This however seems only a relatively limited probability.

There remains no chance of the ECB going for large purchases of sovereign bonds even later in the year, unless a major adverse shock occurs. Frankfurt is always concerned that unconditional sovereign debt purchases will ease the pressure on euro area elected leaders to tackle the region's deep structural problems. The ECB does not want to damage the political consensus underpinning its successful outright monetary transaction program.

The ECB is about to do something, but will still refuse to do it all.


1. Euro area quarter-over-quarter Q1 GDP growth at 0.2 percent was the same as in Q4 2013, while short-term Purchasing Manager Index (PMI) data have similarly stagnated at levels, indicating a very modest ongoing expansion.

2. The maintenance period begins on the settlement day of the first main refinancing operation following the meeting of the Governing Council at which the monthly assessment of the monetary policy stance is prescheduled.

3. Excess liquidity, or the amount of cash beyond what is required to smoothly operate euro area money markets, is generally defined as banks' overnight deposits with the ECB plus current account holdings, minus banks' regulatory minimum reserve requirements and banks' emergency borrowing with the ECB.

4. Data included in figure 1 from May 14–May 30 2014.

5. The ECB's normal 3-month liquidity operations are termed long-term refinancing operations, or LTROs, whereas the ECB's two special 3-year liquidity operations in late 2012 and early 2013 are termed special-term liquidity operations, STROs. See the ECB website.

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