The ECB changes the scale of its operations

The ECB has announced measures to stabilize the money market and measures which will bring more liquidity at a longer horizon in order to boost credit growth and a more sustainable growth recovery.
This will keep interest rates at a very low-level for an extended period, at least until the end of 2016. This will have a long-lasting downward effect on the interest rates structure, peripheral countries included. Even with a negative deposit facility rate, I don’t think that the euro exchange rate will drop. The current account surplus of the Euro Area is large and here to stay. That will maintain a strong euro exchange rate.
Targeted operations on credit will transfer credit risks from the banking system to the ECB. But this transfer will be temporary. The length of the operation is limited to four years. This could be a boost for the development of credit but there are still uncertainties on the banks’ willingness to renew a kind of operation that was put in place at the end of 2011 and beginning of 2012. As I mentioned in an earlier post (here), will it be sufficient to exit from a risk of deflation? That’s the question because the inflation rate will not converge to its target before 2017 – 2020. It’s still far in the future.

Measures taken by the ECB

  • The three main ECB interest rates have been reduced. The refi rate was decreased by 10 bp to 0.15%, the marginal lending facility dropped 35bp to 0.4% and the deposit facility rate dropped 10 bp to -0.10%
    This is the first time since the Eurozone inception that a ECB interest rate is negative. The objective was to maintain a significant spread with the refi rate.
  • Mario Draghi has announced that this low-level would be maintained for an extended period. Interest rates will change effectively on June the 11th.
  • The ECB has also announced the end of the sterilization of the SMP portfolio. Recently the ECB was no more able to sterilize this portfolio. This will bring more stable liquidity to the money market in order to reduce its volatility. This will stabilize the level of EONIA
  • The ECB has also announced a new type of operation: A Targeted Long Term Refinancing Operation (TLTRO). This new measure will be targeted on loans to non-financial agents of the Euro Area. Mortgage loans will not be included in the package. It will be put in place in September and December 2014. The operations’ length will be of 4 years max and the amount of liquidity a bank can have could represent up to 7% of the total of its loans. For the first two operations, the amount available (the 7%) will be measure from the stock of loans at the end of April 2014. From March 2015 to June 2016, banks will have the possibility to increase the size of their own operation with the ECB.
  • The ECB expects that the operation’s size will initially be EUR 400bn.
  • The TLTRO will stop in September 2018 but banks will be able to exit 24 months after the beginning of the operation.
  • The cost will be the refi rate + 10 bp
  • During the press conference, Mario Draghi said that a specific reporting will be done on this TLTRO to be sure that the amount of liquidity is oriented to new credit. If it was not the case, sanctions could be taken from September 2016
  • The ECB is preparing purchases of ABS. There are no details because before that, the ABS market has to be improved. But the ECB is trying to improve this market as ABS purchases are probably its preferred type of operation.
  • Short term operations from the ECB will continue at fixed rate and full allotment. LTRO (3 months) will be put in place. These types of operations will be maintained at least until December 2016.
  • A QE measure, larger than what has been announced, is possible if it is needed. But it’s not on the agenda yet.

During his introduction, Mario Draghi has presented the new ECB forecasts for growth and inflation. GDP growth is expected to be 1% in 2014, 1.7% in 2015 and 1.8% in 2016 for the Euro Area (1.2%, 1.5% and 1.8% respectively were expected in March). The inflation rate is expected to be 0.7% in 2014, 1.1% in 2015 and 1.4% in 2016. Mario Draghi said that inflation rate during the last quarter of 2016 would be 1.5%. (Numbers were 1%, 1.3%, 1.5% and 1.7% respectively in March).
Mario Draghi has mentioned that there were still downside risks on growth due notably to a weak internal demand momentum. Risks are perceived as more balanced on inflation and Mario Draghi do not think that there is a risk of deflation for the whole Euro Area.

Few remarks on these measures

  • The low-interest rates for an extended period will reduce the cost of operations linked to monetary policy (TLTRO, LTRO). The new level will be maintained at least until December 2016 but we cannot exclude that they will remain at this low-level until September 2018. (end of the TLTRO)
  • The negative rate on deposit facility is technical in order to maintain a significant spread with the refi rate. Both dropped by 10bp. But this is also a kind of tax on banks’ deposits at the ECB. This could be an incentive for banks to make more loans. The recent Danish experience said that the impact on credit was limited. It also suggests that the impact on the exchange rate was limited also
    The ECB was not very enthusiastic on this measure. The reference to Denmark was often mentioned. But for technical reason they wanted to keep the spread with the refi rate. I’m not sure that the ECB expects a lot from this measure.
  • Expectations on the Euro exchange rate are not on a rapid depreciation. The current account surplus is large and is here to stay. As Mario Draghi said during its press conference, there is a downside risk on growth due to weak internal demand. So a boost on imports cannot be expected and the large surplus will continue. Euro will keep strong
  • These changes on interest rates will maintain pressures on the Euro Area yield curve. One aspect of the ECB measures is to keep the whole spectrum of interest rates as low as possible, peripheral countries included.
  • The end of sterilization on the SMP portfolio will bring EUR 165bn on the money market. This will create more stable conditions on it. The reason of the sterilization was risk management. In 2011 and 2012, the ECB has bought sovereign debts from peripheral countries (mainly Spain and Italy) but it was just to reduce the risk on the Euro Area. The ECB wanted to limit the impact of these new liquidities on the conduct of its monetary policy. That was the reason of sterilization. Now the situation is really different. Moreover, it was complicated for the ECB to sterilize in recent weeks. This will bring a larger and stable amount of liquidity on the money market that will reduce its volatility. The predictability of short-term interest rates will be higher and the uncertainty reduced.
  • All the other operations have a longer time horizon and can be linked in an easier way to macro economy.
  • The LTRO and TLTRO will reduce the uncertainty for banking and financial sectors. Full allotment and fix interest rate for 3 month operations will limit risk until December 2016. This will push down all the money market rates. The 3 month Euribor will be close to and below the refi rate.
  • On the TLTRO there are a lot of questions
    • It’s a long-term operation (4 years)
    • It will start after the results of the Asset Quality Review (AQR). It’s easier to have this sequence to avoid a conflict between objectives for the banking sector. It will be interesting to see how things will work if after the banking stress tests there is a need for capital as it will have to be managed at the same time than the TLTRO
    • The operation will be 4 years at maximum and 2 years at minimum. It means that at the end of the operation, loans will come back on banks’ balance sheet. The loans quality has to be sufficient enough to be sure that in 4 years the risk will be limited.
    • It is not an unlimited transfer of risks from the banking sector to the ECB. It is just a temporary one. It is deeply different from a QE operation which is a definitive transfer of risks.
    • The idea is to transfer risk in order to create an incentive, with the new liquidity, to take new risks and to make new loans to the economy.
    • A 4 year horizon also means that there is the expectation that in 4 years from now the economic situation will be stronger. The same type of expectations was attached with the 3 year LTRO at the end of 2011.
    • The growth profile that is anticipated by the ECB is mild and limited to 2% at the top of the cycle. Is it a strong incentive for banks to rapidly increase their amount of loans?
    • There is another question: after the results of the AQR and the end of the 2 previous LTRO, what will be the incentives for banks to engage in this new TLTRO? Probably this is just a temporary situation before launching operations on ABS. I think that those real incentives will be seen with this new step. This means that changes on the ABS have to be done rapidly.
    • Last remark: with operations ending after December 2016 and until September 2018, the ECB can be able to neutralize the Federal Reserve hike on its interest rate. In other words, there is a risk of contagion from the US to the Eurozone when the Fed will increase its interest rates. ECB measures can limit the contagion.

The ECB monetary policy is more accommodative and its predictability is higher. This can boost growth and reduce uncertainty. But to converge to a stronger growth trajectory and to the ECB inflation target the ECB action will not be sufficient (see here to see that the low inflation rate is not just a monetary phenomenon). It is a concern for everyone. That’s what Mario Draghi said at the end of his introduction saying that reforms have also to be done in order to boost growth and to converge to a more balanced path.

The coming period will be important for the Euro Area and measures from the ECB are essential as in the coming couple of years, the BoE and the Federal Reserve will probably increase their interest rates. The contagion can be reduced.
The success of these measures will condition the ECB credibility, the financial stability of the Euro Area and at the end the future of the Euro Area.

3 thoughts on “The ECB changes the scale of its operations

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