In a recent Vox column, Aaron Tornell and Frank Westermann (2012) argue that with the conduct of three-year liquidity operations, the ECB has “hit a limit in its ability to prevent an acceleration of inflation”. They take issue with a statement by ECB President Mario Draghi that the ECB would react promptly to a worsening inflation outlook.
Tornell and Westermann’s main argument is that the ECB would not be effective in raising interest rates because short-term lending to banks is currently very limited in view of the large long-term operations outstanding. Therefore, an interest rate increase would not be very effective. They also argue that raising minimum reserve requirements might put some banks under strain; that asset sales would have undesirable implications in financial markets; and that raising the deposit rate paid to banks would risk imposing losses on the central bank.
This analysis overlooks four points that together suggest that the ECB has by no means reached a limit in its ability to fight inflation despite the large volume of outstanding three-year operations, and that the risks of a sudden spike in (core) inflation are actually very limited.
1. The first and most important point to add to Tornell and Westermann’s analysis is that the interest rate on the three-year operations is not fixed at 1%. Rather, it is indexed to the main ECB policy rate, that is, the rate on the main refinancing operations. If this rate were to rise, the costs for the remaining period of the three-year LTROs would also rise.
The overall costs in these operations reflect the average of the main refinancing operations over the entire three-year period. That is why the three-year liquidity allocation does not stand in the way of an increase in short-term interest rates and would rather allow such an increase to be immediately translated into the outstanding liquidity operations. Hence, a rate hike would be fully effective.
2. The second point is that changing the main refinancing rate is not the only tool that the ECB would have to deal with outstanding liquidity. It could raise all of its policy rates including in particular the rate on its overnight deposit facility, currently at 0.25%.
Contrary to what Tornell and Westermann suggest, the ECB would make no losses from such an increase because the deposit rate would in no case exceed the rate on the liquidity providing operations. It would make lower profits, but profit-generation is not an objective of the ECB. As a consequence of a higher rate on the deposit facility, the inter-bank market rate – the so-called Eonia rate, currently at around 0.35% – would, of course, also rise because banks would not lend to other banks at lower rates than they can get from the ECB.
In this sense, an increase in the deposit facility rate would have, everything else unchanged, an equivalent effect on short-term interest rates. Whether this would be an appropriate way to signal a change in the monetary policy stance, is a decision by policy-makers; technically, it would be feasible and effective.
Further instruments are also conceivable. The ECB could tender longer-term deposits if it wanted to lock-in the liquidity at longer maturities. And it could activate the issuance of debt certificates, which are an instrument foreseen in its monetary policy operational framework.
3. The third point when discussing potential risks of inflation is that it is not the balance sheet of the central bank but the balance sheets of commercial banks that are relevant because the latter show the interactions with the real economy. The former only shows that the central bank is currently replacing the intermediation function owing to the malfunctioning interbank market.
Of the roughly €1.2 trillion provided to commercial banks in liquidity-providing operations (of which about €1.1 trillion is over three years), roughly €750 billion is still on the ECB’s deposit facility and about €100 billion is blocked as required reserves held with the central bank (Figure 1). The remainder, about €350 billion, is to cover other structural elements of liquidity demand, such as banknotes.
This compares with a situation before the three-year operations were launched in mid-December 2011 when the ECB provided about €720 billion in liquidity, about €220 billion was held as deposits with the ECB and about €200 billion was blocked as required reserves.1 At that time, remaining elements of liquidity demand added up to about €300 billion.
Figure 1. ECB operations before and after the three-year operations
This means that the actual need of the banking sector for central bank liquidity has hardly increased as a result of the three-year operations between mid-December 2011 and end-March 2012. That is not surprising because the commercial banks’ lending behaviour has not changed much since then. The main change from the operations is that banks now have in principle liquidity available on a three-year horizon, should they need it.
One therefore has to monitor carefully to what extent the higher liquidity available to the banks will change their own lending and investment behaviour – that is, how this liquidity is fed into the economy and whether this could give rise to possible inflationary pressures. This is likely to be a very gradual process2 and will be reflected in monetary aggregates and in loans as their main counterparts.
Here the picture had been bleak: last year, M3 had fallen three months in a row in absolute terms – something not seen before in the history of Europe’s economic and monetary union – and loans had fallen two months in a row. In recent months, M3 growth has turned positive again and now stands at 2.8% year-on-year. This is still less than half the average rate of growth of 6% since the inception of the euro.
Likewise, the monthly rate of growth of loans to the private sector had recovered to positive territory in January but in February contracted again. On an annual basis, it currently stands at around 1.1%. Even if the rate of loan growth in the past may be biased upwards in a number of euro area countries by excessive lending in the run-up to the crisis, the fact that the current expansion is only a fraction of the long-term average annual growth rate of 7% since 1999 suggests how weak credit growth still is overall (Figure 2).
Figure 2. Credit growth in the euro area and selected countries, 2007-present (annual rate of growth, in percent)
Note: Bank loans to non-financial corporations; EA=Euro Area.
Source: ECB (BSI statistics).
The macroeconomic picture does not suggest a strong increase in demand for liquidity balances. Consumption is estimated by ECB staff to contract by about 0.3% this year; investment to contract by 1.2%.3 These projections do not suggest a sudden pick-up in net liquidity demand from a macroeconomic perspective.
4. Inflation expectations both over the medium and longer term remain well anchored. The expected average annual inflation rate derived from financial markets for the next five years stands currently at 1.7%. The five-year five-year forward – the five-year inflation rate expected for five to ten years – currently stands at 2.2% (Figure 3).
Figure 3. Financial market based inflation expectations
Note: Zero-coupon euro area break-even inflation rates.
Source: ECB calculations.
Subtracting inflation risk premia, long-term inflation rates are fully consistent with the ECB’s objective. Inflation expectations are also below levels observed on a comparable basis in the US or UK (Figure 4.)4 The latest Survey of Professional Forecasters (SPF) currently puts the euro area longer-term inflation rate at 2%.5 The current inflation rate of 2.7% is driven by higher oil prices and indirect taxes, while the core inflation rate is currently about 1.6%.
Figure 4. Inflation expectations in an international comparison
Note: 5-year forward 5-years ahead break-even inflation rates.
Source: ECB calculations.
In conclusion, these points suggest that all interest-rate tools and tools of liquidity-absorbing operations remain effective, also in view of the special outstanding operations. Therefore, should potential inflationary pressures arise, the ECB Governing Council has all the tools available to counter them.
Author’s note: Views expressed in this column are those of the author and do not necessarily represent views of ECB decision-making bodies.
1 At the time, the ratio of required reserves was still 2%; it was cut to 1% together with the implementation of the three-year operations.
2 Note that in Japan, banks have been operating in an excess liquidity environment for a very long time without this having generated inflationary pressures.
3 See ECB Monthly Bulletin, March 2012, Box 10, pp. 88ff.
4 Latest developments regarding market-based inflation expectations are discussed in Section 2.4 of the ECB’s Monthly Bulletin. An overview of the underlying methodology is provided in Box 5 of the December 2011 Monthly Bulletin (“Estimating real yields and break even inflation rates”); the methodology itself is explained in detail in “The term structure of euro area break-even inflation rates”, by J. Ejsing, J. A. García and Thomas Werner, ECB working paper no. 830.
5 The SPF is a quarterly survey of expectations for the rates of inflation, real GDP growth and unemployment in the euro area for several horizons, together with a quantitative assessment of the uncertainty surrounding them. Results are published on the ECB website.