ECB confirms monetary policy has run its course – Part 1

I will have little time to publish blog posts in the next two weeks. But as I travel around I have to sit in trains, planes and cars and that is when I tend to write when I am away from my desk(s). Today, I am in Maastricht – after travelling by train from Paris. I have two events – one on framing and language and the other on Reclaiming the State and Modern Monetary Theory (MMT) basics. Then I am heading to Berlin for a talk at PIMCO and on Friday I am presenting an MMT workshop at the European Central Bank. Last week, the ECB made its next move, the last one for current President Mario Draghi. It will also lock in Madame Lagarde for a time and represents a rather overt statement about the failure of mainstream macroeconomics. While the mechanics of their various policy decisions are interesting and are worth discussing (albeit briefly) the overall optics were more powerful. The ECB has now joined a host of central bankers around the world in, more or less, admitting that monetary policy has run its course and is being pushed into ever more desperate configurations. At the same time, the corollary is that fiscal policy makers are failing in their responsibility to use policy to avoid stagnation and elevated levels of unemployment. Despite rather significant monetary policy gymnastics, aimed at stimulating economic growth and lifting inflation rates, central bankers have largely failed. They have failed because they are wedded to mainstream theory. Fiscal policy makers are constrained by an austerity-biased ideology and/or voluntary institutional machinery that has been created to stifle fiscal initiative (destructive fiscal rules). The cracks are widening. We are approaching the period of fiscal policy dominance – finally! This is Part 1 of a two-part series on this topic. Part 2 will follow tomorrow.

The ECB’s latest decision

On September 12, 2019, the Governing Council of the ECB released their latest – Monetary policy decisions.

In summary (with analysis):

1. The ECB determined that:

The interest rate on the deposit facility will be decreased by 10 basis points to -0.50%. The interest rate on the main refinancing operations and the rate on the marginal lending facility will remain unchanged at their current levels of 0.00% and 0.25% respectively … key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% …

Whereas previous ECB policy positions were defined in terms of end-dates, the current stance is no open-ended and dependent on a particular inflation outcome being achieved.

And with the inflation trajectory going in the opposite direction it might be some time before rates rise.

To understand what is going on, we need to understand that the ECB sets “three key interest rates”:

(a) The deposit rate “which banks may use to make overnight deposits with the Eurosystem at a (pre-set) rate lower than the main refinancing operations rate.”

This is the rate that the ECB pays banks for reserve balances.

It defines the lower bound of the corridor for the overnight rates in which “the banks lend to each other” move. The latest decision moves that rate to -0.5 per cent.

(b) The refinancing rate – “banks can borrow liquidity from the Eurosystem against collateral on a weekly basis, at a pre-determined interest rate”.

This is the major way in which the banks borrow from the ECB. It is currently set at zero per cent.

(c) The marginal lending facility rate “which offers overnight credit to banks from the Eurosystem at an interest rate (also pre-set) above the main refinancing operations rate.”

Banks can borrow overnight from the ECB but at a penalty to the weekly refinancing rate.

This rate defines the upper bound of the corridor for the overnight rates in which “the banks lend to each other” move. It is currently set at 0.25 per cent.

The three rates also are obviously related to each other.

To ensure the banks continue to lend among themselves – the so-called functioning money market – there has to be some separation in these rates.

So the corridor in which the main refinancing rate moves is currently set at an upper bound of 0.25 per cent and a lower bound of -0.50 per cent.

2. The ECB also determined that:

Net purchases will be restarted under the Governing Council’s asset purchase programme (APP) at a monthly pace of €20 billion as from 1 November … to run for as long as necessary to reinforce the accommodative impact of its policy rates …

And …

3. That:

Reinvestments of the principal payments from maturing securities purchased under the APP will continue, in full, for an extended period of time past the date when the Governing Council starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

I have written about the Asset Purchase Programmes (APP) before (among other blog posts):

– The European Union once again reveals why it should be dissolved (June 27, 2019).

– Eurozone horror story continues (April 25, 2019).

– ECB denial is just embarrassing (April 4, 2019).

– ECB continues to play a political role making a mockery of its ‘independence’ (June 12, 2018).

– ECB is running out of debt to buy – more smoke and mirrors needed (September 7, 2017).

– ECB’s expanded asset purchase programme – more smoke and mirrors (May 30, 2016).

In the past, the APP’s were announced with sunset clauses. This time there is no end-date specified.

The most recent programs are just extensions of the Securities Market Program (SMP) which began life in May 2010 as Member State governments were threatened with insolvency as the GFC ensued.

In my 2015 book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale – I argued that it was this program and the later versions that saved the Eurozone from breaking up.

Further, despite all the claims by the ECB officials that the large-scale government bond purchases were really to ensure the money market had liquidity (so linked to interest rate policy), the reality was and is that the ECB was funding government deficits – albeit via the secondary market bond purchases rather than direct primary purchases – and that this was in violation of the Treaty’s prohibition on ‘bail outs’.

And while the European Court of Justice had ruled against a German entreaty against QE, the fact is that the ECB was not acting in the ‘spirit’ of the Treaty. Thankfully, in this case.

And in doing so, was really filling the missing ‘fiscal’ function in the Eurozone architecture, which the Delors plan had deliberately suppressed by design – and which has largely made the monetary union dysfunctional.

Further, in relation to the latest decision, as the commentators were speculating as to whether the ECB would reintroduce the QE purchases, there were claims that it would be strictly limited because the pool of bonds that the ECB could buy was limited by self-imposed ceilings on the level of Member State bonds they could hold (algined with the Capital Key).

As a result of past APP purchases, the ECB is nearing the limits for some assets.

But for all the talk that these limits would be binding and cause the APP initiative to close in less than 12 months, Mario Draghi made it clear last week – there are no limits beyond 100 per cent (my words).

The current ‘technical’ limits constraining the mix and extent of ECB government bond purchases (aligned with the Capital Key) are purely voluntary.

The ECB can alter the limits at will and will if push comes to shove.

In his – Press Conference – Mario Draghi said there was “a need to act now”.

Why?:

… inflation expectations are not de-anchoring but are re-anchoring at levels between zero and 1.5% which is not our aim.

And on the limits:

… the majority of the Governing Council believed that action was warranted … Now the limits, there was no appetite frankly to discuss the limits for one good reason, because we have relevant headroom to go on for quite a long time at this rhythm without the need to raise the discussion about limits.

And then, watch the limits be raised should the ECB think that is necessary.

Although with Madame Lagarde taking over as President soon, it remains to be seen whether the likes of Bundesbank boss Jens Weidmann and the Banque De France boss Francois Villeroy De Galhau, who allegedly opposed the reintroduction of QE, will bully her into a recantation, given her lack of any central banking experience.

But I also see Madame Lagarde as being appointed despite her lack of experience to try to quell the growing unrest about the lack of fiscal policy action in the Eurozone, which is now a common theme among central bankers everywhere – that monetary policy has run its course.

In that respect, I do not expect her to adopt a pure ‘central bank’ independence role and wlll continue to see the ECB as the default ‘fiscal’ capacity in the Eurozone.

It is a highly inefficient way to run a monetary union – saving Member States from insolvency, while at the same time, participating in harsh conditionality based on austerity to ensure the fiscal rules are broadly obeyed.

And given the legacy of the GFC has still not been expunged – the residual damage remains in debt holdings, zombie banks, degraded public infrastructure, failing public services, elevated levels of unemployment, precarious private pension funds and more – then when the next crisis hits, this inefficiency will once again become a threat to the viability of the currency.

They should deal with the architectural dysfunction now – but they won’t. And that is the problem.

4. The ECB also announced that:

The modalities of the new series of quarterly targeted longer-term refinancing operations (TLTRO III) will be changed to preserve favourable bank lending conditions, ensure the smooth transmission of monetary policy and further support the accommodative stance of monetary policy. The interest rate in each operation will now be set at the level of the average rate applied in the Eurosystem’s main refinancing operations over the life of the respective TLTRO. For banks whose eligible net lending exceeds a benchmark, the rate applied in TLTRO III operations will be lower, and can be as low as the average interest rate on the deposit facility prevailing over the life of the operation. The maturity of the operations will be extended from two to three years.

What is the TLRO facilty?

According to the ECB, the – Targeted longer-term refinancing operations (TLTROs) – are:

Eurosystem operations that provide financing to credit institutions. By offering banks long-term funding at attractive conditions they preserve favourable borrowing conditions for banks and stimulate bank lending to the real economy.

They were introduced on June 5, 2014, with “a second series (TLTRO II) on 10 March 2016 and a third series (TLTRO III) on 7 March 2019.”

The targetting term relates to the fact that “the amount that banks can borrow is linked to their loans to non-financial corporations and households”.

TLTRO III now offers “refinancing operations, each with a maturity of three years” (up from two years).

There has been a debate about the impacts of these longer-term refinaincing operations.

For example, how does the cheap credit facility impact on non-financial corporations in Europe?

The logic of the program is that by providing this liquidity, the ECB is really channelling funds into non-financial corporations that enables them to invest in productive capital formation and thus stimulate the Member State economies.

I had a long discussion with a leading fund manager in Europe yesterday and we concluded that there was no shortage of ‘savings’ in the Eurozone. Firms, in particular, were cashed up but were not investing in productive outcomes, in part, because the austerity bias of the system (the fiscal rules etc) were stifling a diversity of investment opportunities.

This is not a purely European problem. For example, the same could be said for US and Japanese firms. Apple and Google, for example, are hardly cash-strapped at present.

The LTROs have two aspects: (a) they can increase bank liquidity; and (b) they may increase liquidity among non-financial corporations.

It is not clear that (a) translates into (b), especially if non-financial corporations are risk-averse and do not trust the current policy environment to safeguard productive investments from recession.

The point is that firms have shown a tendency to hoard cash rather than invest in productive capital.

I am currently doing some research on this question – to see whether the LTROs have led to higher levels of productive investment by firms.

The early results suggest not.

It looks like firms are using bank borrowing (at low rates) in order to hold higher levels of cash after the LTROs commenced. Whether this is causal remains to be seen.

Further, it seems that this tendency is more evident among the weaker economies (Greece, Ireland, Italy, Portugal, and Spain) rather than the so-called ‘northern’ economies.

I will report on this further once I have done more research.

But the upshot is that it doesn’t look as though these schemes are really boosting real GDP growth, which is unsurprising really.

In its latest decision, the ECB:

(a) Set the interest rate “at the level of the average rate applied in the Eurosystem’s main refinancing operations over the life of the respective TLTRO”.

This rate is currently set at zero.

(b) If a bank lends over a benchmark “the rate … will be lower” and “be as low as the average interest rate on the deposit facility prevailing over the life of the operation”.

This rate is now -0.50 per cent.

Overall, even though this is providing the banks with cheaper credit than before, the fact remains that the rather weak credit growth in the Eurozone is driven by the lack of demand from credit worthy borrowers rather than the supply cost of finance.

With weak growth and the ever-present danger of reversion back into recession, it is little wonder that demand for investment loans remains subdued.

Conclusion

In Part 2, I will examine the decision by the ECB to introduce a Swiss-style two-tier deposit rate scheme to assuage criticisms that the negative deposit rates were penalising banks with excess reserves and that these penalties were being passed on to corporate and retail borrowers and depositors.

Events today:

I am in Maastricht today for two events:

1. Tuesday, September 17, 2019 – MMT Framing Workshop (PINE Maastricht – 18:00 to 19:00) – public event.

2. Tuesday, September 17, 2019 – Reclaiming the State (PINE Maastricht – 20:30 to 22:15) – public event.

I am looking forward to meeting the students at Maastricht who are challenging the orthodox bias of the teaching programs they are taking and giving them whatever support I can in their quest to introduce a credible economics program.

They are clearly sick of being subjected to the fake knowledge that is mainstream macroeconomics.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.