ECB confirms monetary policy has run its course – Part 2

This is Part 2 of my two-part commentary and analysis of the – Monetary policy decisions – by the ECB (September 12, 2019). In Part 1, I discussed the shifts in the deposit rate and the changes to the Targeted longer-term refinancing operations (TLTROs). In Part 2, I am focusing on the decision to introduce a two-tiered deposit rate on excess reserves, which is designed to reduce the costs of the penalty arising from the negative deposit rate regime that the ECB has had in place since June 2014. But the most important aspect of the ECB decision was not the monetary policy changes, which will have relatively minor impacts on the real Eurozone economy. The telling part of the whole episode was Mario Draghi’s comments on fiscal dominance. We are entering a new era where the neoliberal obsession with so-called monetary policy reliance is becoming increasingly discredited and exposed by the evidence base. Fiscal dominance is approaching. And the only body of work that has consistently argued for this approach to macroeconomic policy making has been Modern Monetary Theory (MMT) despite what the mainstream economists who are now starting to realise their reputations are in tatters might say.

Negative deposit rates go further negative

In its latest decision – spelt out in the Press Release cited in the Introduction, the ECB also decided to :

(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.

The ECB explained the logic of its negative interest rate in this statement (June 12, 2014) – The ECB`s negative interest rate.

The ECB wants monetary policy to be ‘accommodative’ yet, the banks are motivated to pass the cost of the excess reserve penalties onto their borrowers which works against the intent of the policy.

For the German media, the meaning of the ECB’s monetary gymnastics is clear.

Mario Draghi was asked at his press conference to comment on the claims by:

… the CEO of the Deutsche Bank recently said at a conference that if the ECB is continuing this type of monetary policy it may lead or will lead to a destabilisation or a collapse of the financial system

The popular press in Germany is clearly running a campaign against the ECB.

This graphic appeared in the conservative daily German newspaper Bild-Zeitung and depicts ECB boss Mario Draghi as a blood-(saving)-sucking monster preying on the hard efforts by Germans to save.

The Bild story (September 12, 2019) carried the headline “So Draghila sucks our accounts empty. During his tenure we have lost billions”.

Choice.

The story said that Draghi was costing German savers billions in lost euros and his “monetary madness” was “devastating”.

Immediately following this rather scandalous depiction of Mario Draghi, Bundesbank boss, Jens Weidmann, gave an interview to Bild – Ist unser Geld in Gefahr? (September 13, 2019) – or “Is our money in danger?”.

The link is to the English translation provided by the Deutsche Bundesbank. Their translated version (September 14, 2019) carries the heading “Weidmann: ECB Governing Council has gone too far”. I will return to his assessment a bit later.

But the fact he gave an interview to the Bild-Zeitung soon after they had displayed Mario Draghi in that light tells you a lot about the German mentality in this respect.

Anybody else would avoid dealing with a rag like Bild-Zeitung for displaying Draghi as Dracula. Especially when, as you will see later, the German banks will be the largest beneficiaries of the changes the ECB announced last week.

The Financial Times article (September 14, 2019) – There’s a German word for negative rates – said that there is:

… a widespread perception across Germany that the ECB is penalising savers through its monetary policy … former finance minister Wolfgang Schäuble blamed it for 50 per cent of the rise of the anti-European Alternativ for Deutschland party.

The President of the De Nederlandsche Bank, Klaus Knot also joined the chorus.

In an official DNB Press Release (September 13, 2019) – Klaas Knot comments on ECB policy measures – criticised the ECB’s policy decisions, claiming:

This broad package of measures, in particular restarting the APP, is disproportionate to the present economic conditions, and there are sound reasons to doubt its effectiveness.

He claimed that there was no need for any further stimulus as the “euro area economy is running at full capacity”. More on that claim later.

But the idea they are fermenting that interest rates should be increased soon and that the Euro economy is at full employment is an outrageous insult to the millions who remain unemployed!

This view was endorsed by the Austrian central bank governor and some other governing board members.

Mario Draghi responded to the question by acknowledging “the negative side effects on the people especially in those parts of the eurozone where the negative rates are being passed to corporate … depositors”.

He went on:

… the banks would like to have positive rates, unquestionably …

But he denied that the “negative rates would cause the collapse of the financial system because before getting there one has to look at other things of our banks.”

He said that the “certain structural weaknesses in the banking sector” in the Europe were not much to do with the negative deposit rates.

While his language was typically cautious, his statement on this was really reflecting on the poor management of the commercial banks, that have grown used to taking positions of excessive risk to grab profits out of the system, and, then, when the risk impacts and the strategies backfire, they put their hands out for public sector bailouts.

Privatise the gains, socialise the losses – the neoliberal way!

The two-tiered deposit approach

Accompanying the decision to go further into the negative range for the deposit rate, the ECB determined that:

In order to support the bank-based transmission of monetary policy, a two-tier system for reserve remuneration will be introduced, in which part of banks’ holdings of excess liquidity will be exempt from the negative deposit facility rate.

Both Japan and Switzerland have introduced tiered systems for bank reserves, although their particular schemes differ in design.

The bottom line is that once the deposit rate is negative, banks are then punished for holding excess reserves. The deposit rate has dropped from -0.4 per cent to -0.5 per cent.

The following graph shows the evolution of excess reserves in the Eurosystem from its inception to July 2019. The early spike relates to the LTRO scheme and the subsequent decline was due to the fact that as financial stability improved the banks took advantage of ECB rule changes to pay back the refinancing liabilities ahead of schedule.

You can read about that in the ECB – Ad hoc communications.

The subsequent positive spike relates more to the continued ECB QE bond purchases.

One of the features of Modern Monetary Theory (MMT) that is neglected by mainstream macroeconomics and monetary theory is the concept of bank reserves.

The mainstream treatment of bank reserves is mostly wrong.

Students learn that reserves are necessary for banks before they can make loans, as if they make the loans from the reserves – both propositions are not applicable to a real-world monetary system.

It is crucial to understand why, because that understanding allows us to correctly, in this case, appraise the ECB’s decision in relation to excess reserves.

Banks do not loan out reserves to retail customers.

Rather, bank reserves are an integral part of the ‘payments system’, where commercial banks use their exclusive accounts with their relevant central bank to settle transactions between themselves.

So, on any particular day, a multitude of transactions occur that have claims on funds between banks (for example, Bank A customer deposits a cheque from Bank B Customer which has to be cleared).

In some jurisdictions, the payments system has been referred to as the ‘clearing house’, harking back to when there were a lot of paper cheques that had to be reconciled each day.

Banks try to assess their daily reserve requirements but also, typically, will not choose to hold in excess of those clearing requirements because the reserves usually return less than a commercial return.

As we know, the deposit rate in the Eurozone, for example, is now -0.50 per cent. A ‘penalty’ rate on excess reserves.

Banks reserves also play a crucial role in the operations of central bank monetary policy. Reserves are provided exclusively by the central bank although that does not mean that the central bank can reasonably control their level.

I won’t go into the detail of how reserve accounts have broadened in some jurisdictions (for example, Britain) to include non-bank financial institutions. That sort of detail is unnecessary here.

Central banks use reserves management as a means of implementing their monetary policy – that is, maintaining a particular short-term policy interest rate.

So, typically, if there are excess reserves, which would otherwise drive the short-term rate down below the current policy rate, because the competitive process whereby banks try to loan those reserves to each other drives the rate down, the central bank would sell interest-bearing securities and drain the reserves.

And vice versa in the case of a shortage of reserves.

In the current post-GFC environment, central banks just pay a support rate on the reserves and this quells any incentive of banks to try to rid themselves of excess holdings.

It eliminates any need for the central bank to engage in traditional open-market operations (selling bonds and draining excess reserves or vice versa).

In this case, there is little difference between a reserve balance and a holding of short-term government debt – both are highly liquid (can be exchanged for cash at will) and both deliver some a return on holding (usually). The only real difference is the ‘name’ on the central bank account that records their existence.

The point to be clear about is that when MMT economists talk about the government currency-issuing capacity (which allows us to conclude that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency), we are not talking about ‘money’ in the way people usually think about that term.

We are, instead, talking about the monopoly supply of bank reserves from the central bank and actual cash.

Many critics, who haven’t read our work closely enough, but conclude they are experts nonetheless, miss this point, when they claim that MMT is wrong in asserting that the government is the sole source of currency because banks creates deposits whenever they create loans.

The latter point is true – loans create deposits – which bears on the mistakes that mainstream monetary theory makes when it thinks deposits are needed before loans can be made.

But while banks can create ‘money’ in that broad sense, it is not the same ‘thing’ as currency creation.

Further, fiscal deficits push reserves up on a daily basis. This process helps us to understand why the claims that government borrowing pushes up interest rates and crowds out private investment is contrary to the reality.

If the central bank does nothing, then the pressure on interest rates from on-going deficits is downwards not upwards. Of course, the central bank might construe that the fiscal deficits are likely to be inflationary and push up rates through policy decisions.

But this is an entirely different argument than that based on ‘classical’ loanable funds reasoning, which Keynes negated convincingly in the 1930s, but which has resurfaced in this neoliberal era.

The other point to understand is that QE programs also increase bank reserves and contributing to the growing excess reserves in the system.

In this way, as we will see, there is a tension between a negative deposit rate policy stance, which penalises excess reserves, and QE which add to the excess.

The decision to introduce tiering reflects the fact that the various policy initiatives are not internally consistent.

The reduction in the deposit rate provides an incentive for banks to reduce their excess reserves.

But QE does the opposite because it works against the banks’ desire to run down reserves. In a QE system, the volume of reserves in the system are driven by the central bank – they are what we call supply-determined by the extent of the bond-buying program.

Without the QE system, the level of reserves in the system are at the call of the commercial banks with the central bank standing ready to supply the level demanded.

And so at present, if there are excess reserves in the banking system, the banks themselves cannot eliminate that, even though and individual bank can reduce their excess by pushing it onto another bank.

Do some arithmetic:

1. As at July 2019, the ECB reported that Excess reserves for credit institutions that are subject to minimum reserve requirements stood at 1,204,271 million euros.

2. The current penalty on those credit institutions for holding those reserves at the ECB would be 4,817 million euros over 12 months.

3. The new penalty (-0.05) will rise to 6,021 million euros.

4. Then add in the next round of QE (APP) and that penalty rises as more reserves are forced into the system by the ECB.

The tiering initiative is designed to reduce the costs on the banks and those with bank deposits. It means that the reintroduction of QE can go hand-in-hand with further movements into the red for the deposit rate without increasing the costs on the banks.

How?

The ECB Press Release (September 12, 2019) – ECB introduces two-tier system for remunerating excess liquidity holdings – noted that:

1. “All credit institutions subject to minimum reserve requirements … will be eligible for the two-tier system”.

2. “The two-tier system will apply to excess liquidity held in current accounts with the Eurosystem but will not apply to holdings at the ECB’s deposit facility.”

3. “The volume of reserve holdings in excess of minimum reserve requirements that will be exempt from the deposit facility rate – the exempt tier – will be determined as a multiple of an institution’s minimum reserve requirements.”

4. “The multiplier that will be applicable as of that maintenance period will be set at 6.”

5. “The exempt tier of excess liquidity holdings will be remunerated at an annual rate of 0%. The non-exempt tier of excess liquidity holdings will continue to be remunerated at zero percent or the deposit facility rate, whichever is lower.”

So do the sums again:

1. As at July 30, 2019, the excess reserves stood at 1,204.3 billion euros (Source).

2. The overall required reserves were 132 billion euros.

3. So 6 times 132 = 788.4 billion euros, which comprise the ‘exempt tier’ from the deposit rate of -0.5 per cent.

4. Thus, when the deposit rate was -0.4 per cent without the tiered approach, the penalty was 4.81 billion euros. With the tier at the deposit rate of -0.5 per cent, the penalty falls to 2.078 billion euros, a ‘saving’ of 2.738 billion euros.

And who benefits from the tiering initiative the most?

You got it – the German banks.

They account for around 35 per cent of the excess reserves in the Eurosystem.

French banks account for around 22.5 per cent of the excess, Dutch banks 12 per cent, then banks in Finland, Luxembourg and Spain.

I will write about the distribution of the excess reserves – the reasons and implications – in a later blog post.

But the point is that the German banks gain the most from the introduction of the two-tier system.

The period of fiscal dominance is approaching

The most important aspect of the ECB’s latest policy machinations is that they broaden the group of commentators and observers that are realising that monetary policy is being pushed further into the non-standard realm yet the effectiveness of these shifts is increasingly questioned.

The ECB has been forced by the straitjacket that the Treaty laws have placed Member State governments in to increasingly entertain so-called ‘non-standard’ monetary interventions.

We have an array of policy interventions that the ECB has introduced over the last seven years in a desperate attempt to maintain their price stability charter (they have failed) and stimulate the stagnant European economies (mostly failed).

While previous ECB policy positions were defined in terms of end-dates, the latest statement makes it clear that interest rates will remain low:

… until we have seen the inflation outlook robustly converge to a level close to, but below, 2%.

The most significant point that emerged from the ECB’s press releases and interviews last week, was Mario Draghi’s insistence that:

First of all let me start from one thing about which there was unanimous consensus, unanimity, namely that fiscal policy should become the main instrument … it’s quite clear that in order to raise demand in an effective … you’ve seen the language of the Introductory Statement after many years I think of being more or less the same about fiscal policy that has changed and I think there was complete agreement about that …

… it’s high time I think for the fiscal policy to take charge.

The ECB is thus now joining the chorus despite renegade statements from officials from the Bundesbank, Nederlandse, and the Oesterreichische Nationalbank, and others who continue to claim that the Eurozone is operating at full employment and that interest rates should rise not fall.

Bundesbank boss Jens Weidmann said in the Bild-Zeitung interview that it was crucial, in the words of Bild, that “monetary policy does not become harnessed to fiscal policy, because that jeopardises the central bank’s ability to keep prices stable.”

In his own words, he told the newspaper that:

The decision to buy even more government bonds has exacerbated this risk, and it is becoming increasingly difficult for the ECB to exit this policy.

The problem for the likes of Weidmann is that the horse bolted long ago and the evidence base fails (dramatically) to support his inflation obsession.

Conclusion

The most important aspect of the ECB decision was not the monetary policy changes, which will have relatively minor impacts on the real Eurozone economy.

The telling part of the whole episode was Draghi’s comments on fiscal dominance.

We are entering a new era where the neoliberal obsession with so-called monetary policy reliance is becoming increasingly discredited and exposed by the evidence base.

Fiscal dominance is approaching.

And the only body of work that has consistently argued for this approach to macroeconomic policy making has been Modern Monetary Theory (MMT) despite what the mainstream economists who are now starting to realise their reputations are in tatters might say.

That is enough for today!

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