ECB Watch: ECB updates operational framework
Long awaited but still earlier than expected, the ECB communicated some key principles for implementing monetary policy and providing central bank liquidity. Not all is clarified yet and most of the changes are only relevant in the longer-run. The deposit rate will remain the ECB's key interest rate to steer short-term money market rates - like now. The main refinancing rate will be set only 15 bp above it from September 2024 onwards - that's new. Main refinancing operations will become important as a source of liquidity for banks - once again. Conditions remain as generous as they are now: fixed-rate, full allotment against broad collateral. The longer-run consequence for short-term money market rates should be somewhat higher spreads to the ECB's deposit rate and more volatility but still well behaved. On the ECB's bond holdings information remains sketchy. The run down of APP and PEPP will continue as outlined. A new structural portfolio will be introduced at a later stage but not before quantitative tightening has ended. It can be questioned whether this new portfolio will be implemented before the next review is due in 2026. The minimum reserve ratio remains at 1% with a remuneration at 0% - no change.
The key take-aways are:
In December 2022 the ECB started a review of its operational framework. This has now been concluded and the ECB released a statement after its non-monetary policy Governing Council meeting on March 13. It contains key principles of how the Governing Council will steer short-term money market interest rates and, thus, how the ECB implements monetary policy. In the press release President Lagarde stated: "The framework will ensure that our policy implementation remains effective, robust, flexible and efficient in the future as our balance sheet normalises." Let's have a look!
One of the more imminent changes affects the corridor which is spanned by the ECB's key interest rates. From September 18, 2024 on the main refinancing rate will be set 15 bp above the deposit rate, currently it is 50 bp. The marginal lending rate will continue to be set 25 bp above the main refinancing rate. Thus, the corridor between the deposit rate and the marginal lending rate will be 40 bp instead of 75 bp today.
Is this important? For banks, who want to source liquidity from the ECB it obviously is. For short-term money market rates it might be but that depends on how the ECB sets other parameters. The key parameter in that respect is the amount of excess liquidity the ECB wants to keep. And in that respect the ECB has kept a rather low profile in the current review. What the ECB, however, states with respect to short-term money market rates is that:
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The monetary policy stance is best implemented by steering short-term money market rates closely in line with monetary policy decisions - this means that short-term money market rates should reflect changes in the ECB's key interest rates almost 1:1.
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The monetary policy stance is steered by adjusting the deposit facility rate - this means that short-term money market rates are intended to trade in the vicinity of the deposit rate not the main refinancing rate and not the marginal lending rate.
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Some volatility in money market rates can be tolerated - this means that excess liquidity does not necessarily be as abundant as to eliminate any market driven fluctuation in short-term money market rates.
The latter suggests that the ECB's future liquidity provision to the banking sector will be neither scarce - like in pre-financial crisis times - nor abundant - like it is now and has been in the last decade. One has to say that the ECB was much less clear with respect to their future liquidity setup than the Fed or the BoE (for a comparison see our note from last summer: ECB Watch: The future of liquidity). What we know from the review is that the ECB intends a combination of refinancing operations and asset purchases: "provide central bank reserves through a broad mix of instruments".
Main refinancing operations (MROs) are intended to play a central role once again. Currently, this is clearly not the case! These weekly tenders saw a demand from euro area banks of around EUR 5 bn on average in 2024. To give some perspective: total assets of euro area banks are around EUR 37,400 bn and central bank reserves EUR 3,500 bn. If MROs, or other standard forms like 3-month LTROs, gain much more importance once again, the ECB's liquidity provision turns more demand oriented. For this to understand it is important to know that the ECB intends to keep the current characteristics of refinancing operations: fixed-rate, full allotment, against broad collateral. Thus, a bank can borrow as much as it wants from the ECB at the price of the main refinancing rate (15 bp above deposit rate) given that enough collateral is provided. Now it is getting tricky though! If there is a strong element of demand driven liquidity provision, the main refinancing rate and not the deposit rate should be the marginal price and steer short-term money market rates. It could only be the case that short-term money market rates still trade close to the deposit rate because of the fact that €STR trades below the main ECB key rate by design. Currently, the €STR trades at 3.907% (March 13, 2024) with a ECB deposit rate at 4%. The reason being that not all entities captured by €STR have access to ECB facilities. There has been no communication that this will change such that short-term money market rates should continue to price below the ECB's marginal key rate. Assuming a similar discount, the €STR might then price at or slightly above the deposit rate, not below it.
This will not materialize soon! As long as excess liquidity is so abundant as it is now little will change for short-term money market rates. Excess liquidity is currently only gradually brought down by not reinvesting maturing bonds from APP and from mid-year onwards also PEPP. The review of the operational framework does not want to interfere with that. In general, there is only very vague guidance on the future of asset purchases. What the ECB communicates is that it wants to build a structural portfolio of securities to cover the "banking sector's structural liquidity needs arising from autonomous factors and minimum reserve requirements". Thus, it is not intended to affect the monetary policy stance but provide a basis of central bank reserves. This new portfolio will only be introduced once the ECB's balance sheet starts to "grow durably again". In our view this means that this won't be a topic this year, and possibly also not for next year. Another long-term structural topic we know very little about from the review are "new structural longer-term refinancing operations". We hypothesize that these might have a maturity of one year and are, in one way or the other, linked to facilitate the green transition.
One topic which was specified more clearly is minimum reserves. The minimum reserve ratio remains unchanged at 1% and the remuneration of reserves remains at 0%. There was a lot of speculation in recent months that the minimum reserve ratio might be increased (some argue substantially). This topic is closed, at least until 2026, when a new review is conducted.
Overall, the ECB's review of its operational framework gives some guidance but falls behind expectations when it comes to details. Some important questions, like the relative role of refinancing operations and asset purchases, remain open. In comparison to the Fed and BoE, the ECB seems to have not yet found a common ground on all aspects of its future liquidity strategy.
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Franz ZOBL
Austria Franz joined Raiffeisen Research's Economics, Rates, FX team in 2020 primarily focusing on US monetary policy, benchmark yields and EUR/USD. Prior to joining RBI, he worked as a research economist in the financial sector. He holds a PhD from the London School of Economics and studied at the Vienna University of Economics, the University of Vienna as well as Tilburg University. He is a published author within the field of macroeconomics and has a passion for economic history.
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