What’s left in the ECB toolkit?

July 31, 2019 13:03
Recent ECB bank lending surveys suggest that the impact of unconventional monetary policy on lending rates and volumes has become fairly small. Photo: Reuters

Mario Draghi, president of the European Central Bank, has set a low bar for additional stimulus. The data no longer needs to deteriorate to trigger a policy response; a lack of improvement will do.

Markets now expect rates to go deeper into negative territory and stay there for much longer than anticipated only three months ago. There are good reasons for the ECB to do more. Inflation expectations implied by the market have become de-anchored; trade relations with the United States and the United Kingdom could take a turn for the worse; and the Federal Reserve is set to lower its policy rate, which should push the dollar down.

We expect the ECB’s Governing Council to change its forward guidance and loosen policy in September. Yet more monetary support is unlikely to be very effective at this stage and calls for an important revamp of the ECB’s policy framework.

The ECB sees its different tools as mutually reinforcing, working best when used together as a "package". These are: 1) rate cuts to counteract unwarranted tightening in financial conditions; 2) asset purchases to boost the medium-term outlook for inflation via lower bond yields along the maturity curve; 3) long-term refinancing operations to lower banks’ aggregate funding costs, improve liquidity and repair the transmission mechanism of monetary policy via the banking channel; 4) forward guidance, particularly its state-contingency element, to allow the data to guide interest-rate expectations.

Policy sequencing between rates and asset purchases also means that any recalibration of the date-based leg of its forward guidance ‘mechanically’ extends the period over which investors can expect the ECB to reinvest the principal payments from maturing bonds. This should prolong favorable liquidity conditions and reinforce the downward effect of the forward guidance for policy rates on long-term bond yields.

How much more monetary accommodation can the ECB provide? The boundary can only be estimated "ex-post" as side effects of breaching start to appear. Still, it is probably a little lower than today’s -0.4 percent deposit rate. While euro area banks’ net interest income has fallen since the ECB lowered its rate below zero, the net return on assets has remained steady, suggesting that profitability has not been materially affected.

Nonetheless, Draghi has indicated the ECB would probably introduce a tiered system of bank reserves – under which only a fraction of the excess reserves is "taxed" at the newer lower rate, as is the case with other countries – if it were to cut rates further. But tiering is not as obvious as it sounds. For example, it would help liquidity-rich banks in France and Germany where credit growth is relatively strong. It could also incentivize cash-rich banks to hoard liquidity, pushing interbank rates higher and tightening monetary conditions.

The crucial question is whether additional stimulus would be effective in boosting growth and inflation. The short answer is probably not that much. Recent ECB bank lending surveys suggest that the impact of unconventional monetary policy on lending rates and volumes has become fairly small. With bond yields and spreads already extremely low, it is questionable whether a further decline in yields would incentivize corporates to undertake investment.

Probably an unofficial aim is to ensure the euro doesn’t appreciate as the Fed loosens policy. The danger is that this will draw US President Donald Trump’s ire at a time when he is considering levying tariffs on European car exports to the United States.

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International Economist, Bank J Safra Sarasin