What is to be Gleaned from the ECB's Recent Actions?

14 Aug 2018 - Central Banks & Bullion

The most anticipated action this past week was the European Central Bank's (ECB) monetary policy announcement.

As was widely anticipated, the ECB did not disappoint. The major changes include:

A negative deposit rate;
A reduced refinancing rate to a record low 0.05 percent, down from the 0.25 percent;
A series of long-term repo operations maturing in 2018 to boost private sector non-mortgage finance (€400bn);
Continued fixed rate full allotment liquidity provisions until the end of 2016; and
Indications that an asset backed purchase program (akin to the US quantitative easing) is on its way.

What is to be gleaned from these actions? First, let's look at the reduction in the deposit rate. The ECB cut the MRO rate and the deposit rate by 10 basis points, taking the deposit rate negative for the first time. The new negative rate will be applied on excess liquidity that is not in the deposit facility. Will the "reserve tax" (or, as the ECB would like it known "negative interest rate,") boost profitable lending? The simple answer is no, since banks already know which loans will and will not be profitable. A negative deposit rate is more of a harassment from the viewpoint of bankers rather than an incentive. It is unlikely to have any macroeconomic impact.

Second, the ECB is concerned about the EU periphery, as evidenced by the new Targeted Long Term Repo Operations (TLTROs). The main goal of TLTROs is lower interest rates in periphery EU countries. The TLTROs are slated to terminate in September 2018 at a cost of €400bn and a rate of the MRO rate plus 10 basis points. Overall, the scheme is an attempt at improving private non-bank credit. The September 2018 termination date also indicates that the ECB is not seriously thinking about doing away with their string pushing until at least four years from now.

Third, the ECB is ending the SMP sterilization, which effectively increases the excess liquidity in the market by €164bn. The move sends a semi-strong message that buying assets on an unsterilized basis is no longer taboo.

Fourth, Draghi appears headed towards complete asset backed security purchases akin to the US Federal Reserve. Analysts anticipate the purchases to start late this year or early next year with an amount of around €200bn. Again, as with the SMP sterilization, full-out unsterilized asset purchases along the lines of quantitative easing in the US may push borrowing costs lower, but whether it will make previously unprofitable projects profitable is a big if.

Overall, the effectiveness of the ECB's actions may largely depend on how tough the ECBis on bank capital. Should this past week's announcements improve the costs of financing capital in the periphery, it may alleviate some credit constraints.

Should the economic outlook weaken from here, the ECB will almost certainly balloon its planned quantitative easing package.