Monetary plumbing
Monetary policy decisions within the Eurosystem generally follow a well-defined pattern. Every six weeks, the Governing Council of the ECB, whose members include the governor of the NBB, considers whether the monetary policy stance is still appropriate or should be adjusted. The guiding principle here is the key objective of price stability, defined as a 2% annual increase in euro area inflation over the medium term. If a change of course is deemed necessary, the Governing Council will use the policy instruments in its toolbox. These include various interest rates, credit operations and purchase programmes. The ECB uses these instruments to manage the amount of liquidity in the financial system and steer short-term money market rates (more on this later).
What is monetary policy?
Monetary policy refers to the decisions taken by a country’s monetary authority (such as a central bank) to influence the availability and price of money (interest rates) in the economy. Of course, in the euro area, national central banks and the ECB do not directly determine whether prices rise or fall, but they do have a toolbox of monetary policy instruments they can use to influence inflation indirectly.
Eagle-eyed scrutiny
All this is put into a carefully worded press release, published at 14:15 sharp. Financial market participants pour over every word of this press release, reading between the lines. Half an hour later, ECB President Christine Lagarde addresses a bevy of financial journalists at a tightly orchestrated press conference. Again, market participants watch with eagle eyes. After an hour, Ms Lagarde exits the monetary policy stage, and calm can descend once more.
When President Lagarde leaves the podium, we roll up our sleeves and get to work as monetary plumbers.
These press conferences are also closely followed by the NBB’s Financial Markets Department, as the decisions taken by the ECB Governing Council must be implemented across the euro area by national central banks (NCBs). It is indeed the NCBs that provide liquidity to the economy via different channels. So when President Lagarde leaves the podium, we roll up our sleeves and get to work as monetary plumbers.
The operational framework for monetary policy
This decision will impact the size and future composition of the Eurosystem’s balance sheet (and thus also that of the NBB), albeit only very gradually.
On 13 March 2024, the ECB published a Governing Council statement on its website, announcing changes to the operational framework for implementing monetary policy. The changes concern the ECB’s set of monetary policy instruments and the way in which monetary policy will be conducted in the future. The main objective of price stability, nonetheless, remains unchanged.
The statement received minimal coverage in the non-financial press. Yet it points to fundamental changes in how the ECB will conduct monetary policy going forward. This decision will impact the size and future composition of the Eurosystem’s balance sheet (and thus also that of the NBB), albeit only very gradually.
A piece of history
What was decided exactly and why were these changes needed? A dip into the short history of our single currency sheds light on monetary plumbing and its plethora of acronyms.
Central bank reserves are balances held by credit institutions with an NCB. These reserves represent the safest and most liquid assets in the economy. Credit institutions need these reserves not only to meet the minimum reserve requirements imposed by the Eurosystem, but also to fulfil their payment obligations. These reserves also make up a prominent share of the liquidity buffers of many credit institutions.
What is the short-term money market rate?
The short-term money market rate is the daily rate at which financial institutions carry out short-term borrowing and lending operations among themselves. (Since 2019, this rate has been represented by the €STR or euro short-term rate which replaced EONIA, the euro overnight index average.)
In the early years of the euro, the Eurosystem operated within a “scarce reserves system” or “corridor system”. In other words, the Eurosystem provided just enough reserves to meet commercial banks’ total liquidity needs. In this way, short-term money market interest rates stayed neatly within a corridor shaped by the interest rates applicable to the Eurosystem’s two permanent facilities: the marginal lending facility and the deposit facility.
These two standing facilities (each with one-day maturity) are available to counterparties on a daily basis. Thus, on the one hand, commercial banks can deposit their excess liquidity with the central bank. This so-called deposit facility (DF) allows counterparties to park end-of-day liquidity with the Eurosystem. On the other hand, the marginal lending facility (MLF) allows credit institutions to obtain very short-term (i.e. overnight) liquidity in exchange for appropriate collateral.
Under the scarce reserves system, the one-week collateralised lending operation rate (the main refinancing operations rate or MRO rate) was between the DF and MLF rates. The MRO rate was considered the key policy rate and a guide to short-term money market rates. A well-functioning interbank market ensured the smooth distribution of central bank reserves, resulting in limited use of the standing facilities.
The ECB’s monetary policy gradually evolved from a corridor system to a supply-driven floor system, in which short-term market rates are anchored around the deposit facility rate
DFR = the interest rate on the deposit facility
MLF = the interest rate on the marginal lending facility
MRO = the interest rate on main refinancing operations
Eonia/ESTR = short-term money market rate
This paradigm came to an end with the global financial crisis in 2008. Mutual distrust among credit institutions dried up the interbank market, and policy rates were cut sharply. However, as inflation remained stubbornly below the 2% target, additional measures were deemed necessary.
Echoing Hippocrates’ words that “desperate times call for desperate measures”, the Governing Council introduced a number of so-called non-conventional policy instruments. The Eurosystem engaged in large-scale asset purchases, through a raft of different purchase programmes, and rolled out new longer-term refinancing operations (TLTROs), with attractive terms for credit institutions.
Monetary policy evolved in practice from a “corridor system” to a “supply-driven floor system”, in which much more liquidity was pumped into the banking system than demanded.
The outbreak of the Covid-19 pandemic in March 2020 turbocharged this approach, and liquidity was liberally pumped into the banking system through the new monetary pipelines. This abundance of central bank reserves had the effect of pushing short-term money market rates to the bottom of the corridor. The €STR even fell several basis points below the deposit facility rate, reflecting the intermediation margin (a type of brokerage fee) that banks charge when borrowing liquidity from market participants, such as pension funds or asset managers, without direct access to the Eurosystem’s deposit facility. (This situation is often referred to as a “leaky floor”, which seems somewhat unfortunate in light of our plumbing metaphor.)
Consequently, the deposit facility rate supplanted the main refinancing operations rate as the most important policy rate. Monetary policy had thus evolved in practice from a “corridor system” to a “supply-driven floor system”, in which much more liquidity was pumped into the banking system than demanded.
A revamped monetary policy toolkit
Following Russia’s invasion of Ukraine, the long period of low inflation came to an end, and inflation began to climb dramatically: at this time, central banks worldwide changed tack. Policy rates were raised sharply over a short period of time and the liquidity taps were turned off. The intra-euro area liquidity surplus peaked at €4.7 trillion in mid-2022. Since then, it has declined steadily due, on the one hand, to the repayment of TLTROs and, on the other, to the maturing of bonds purchased by the Eurosystem in recent years.
Against the backdrop of this “normalisation” and given the changed market environment, the question arose as to how and with what tools monetary policy should best be conducted within the Eurosystem. An update of the operational framework was required.
After careful consideration, and taking into account the new environment, the Governing Council opted for a “demand-driven floor system”. Rather than flooding the banking system with reserves – as in a “supply-driven floor system” – or returning to a system in which reserves are kept scarce – as in the traditional corridor system – the amount of liquidity provided would henceforth be determined by banks’ actual liquidity needs.
In a demand-driven floor system, the amount of liquidity provided is determined by banks’ actual liquidity needs.
The Governing Council once again sees a more central role for main refinancing operations with a maturity of one week and longer-term refinancing operations with a maturity of three months. As in previous years, these collateralised credit operations will be conducted with full allotment. The amount of liquidity provided will thus be determined by counterparty demand (in other words, they will be demand-driven).
Moreover, as of 18 September 2024, main refinancing operations with a maturity of one week will be adjusted so that the interest rate differential with respect to the deposit facility will be reduced from 50 to 15 basis points. This smaller interest rate differential will stimulate bidding in weekly operations, likely causing short-term money market rates to move closer to the deposit facility rate.
The deposit facility rate will thus become the main policy rate (i.e. a floor system). Once the Eurosystem’s balance sheet starts to grow sustainably again, longer-term refinancing operations and a structural bond portfolio will also contribute substantially to the liquidity needs of the banking sector.
The NBB’s Financial Markets Department staff are already prepared to put the revised operational framework into practice. After all, what craftsperson doesn’t like new tools?
