Over the last few weeks the words uttered by the ECB President, first in front of the European Parliament and then in the latest press conference, according to which the ECB is: "ready to use all available instruments, including a LTRO (longer-term refinancing operation), to ensure that developments in short-term money market rates are in line with our medium-term assessment of price stability." have attracted a lot of market attention.
The reason for this attention is a false syllogism which can be summarised in three points:
- The ECB has issued forward guidance to have constant or lower interest rates,
- But, also as a consequence of the drying out of excess liquidity, the market is well poised to increase rates ,
- Hence, another very long term refinancing operation (VLTRO), increasing again excess liquidity, would help the ECB win its tug of war with the market.
The problem in this syllogism is in point 3. Another VLTRO would not necessarily help increase excess liquidity. To understand why, a basic fact has to be recalled: unlike in the case of the FED, the amount of central bank liquidity in the €-area is not decided by the central bank but by the aggregate demand of the banking system. Since the ECB decided, in October 2008, to give as much liquidity as desired to banks at its fixed interest rate, it is the bidding behaviour of banks that determines how much liquidity is injected into the system. Setting the issue in a demand/supply framework, one clearly sees that it is demand by banks that determines liquidity, not the infinitely elastic supply from the central bank. Therefore trying to increase the supply of liquidity serves little purpose if there is no demand.
Of course one could object that the decision of the ECB to provide the 2 VLTROs with three year maturity at the turn of 2011 met with huge success, so a "supply" decision did indeed lead to a very large increase of liquidity. The answer to this objection is that the VLTROs were successful just because they met a large potential demand. Thus the issue now refines into a subtler one: what evidence is there that there is potential demand for an additional VLTRO? The answer to this question is: very little. This conclusion can be derived from the following 2 facts:
- The banking system is, in aggregate, returning liquidity to the ECB, as a sign that it judges it has already too much of it; since January of this year, when banks were allowed to return the money borrowed in the VLTRO, they have returned 354 billion of the about one trillion of liquidity they had borrowed and over the last few weeks the pace of reduction was subdued but did not go down to 0,
- There is no evidence that there are some segments of the €-area banking system that are demanding more liquidity, notwithstanding the fact that the system has an excess in aggregate terms; banks needing liquidity could borrow more from the ECB under its outstanding operations, in particular from its 3 month LTROs, but they are doing this only in minimal amounts, as the dominant part of ECB funding is still provided through the two VLTROs.
Market narrative confirms, on a more informal basis, that there is no potential large demand for central bank liquidity in the €-area.
Do all the considerations developed so far imply that there is nothing the ECB can do to maintain a large amount of excess liquidity in the system to avoid that money market rates move from levels close to 0, were they are currently, up to the 50 basis points of the official rate, thus causing an endogenous tightening of monetary policy equivalent to 2 quarter point increases? The answer to this question is a clear no. Putting the issue again in terms of tug of war between the ECB, wanting constant or lower rates, and the market, set to increase them, there are two kinds of tools the ECB could use to win the contest:
- Lowering the official rate, from 50 to 25 basis points,
- Giving incentives to banks to hold more liquidity, thus enhancing potential demand from the banking system.
Of course the two measures could be taken separately or jointly, in which case their effectiveness would be enhanced.
For instance, the ECB could lower rates to 25 basis points and then offer another VLTRO, this time with fixed rate (and not with floating rate as the existing operations): the prospect of having a source of funding at very low cost for an extended period of time would create substantial incentives to demand more liquidity from the central bank.
Alternatively, the ECB could offer a VLTRO with some kind of optionality to give incentives to banks to participate: for instance the ECB could offer a VLTRO with an option for a bidding bank to move from floating to fixed rate when the ECB would lower the official rate or at any time the bank would so decide. This kind of operation would protect the bank from the risk of higher rates and give an incentive, albeit weaker than in the previous case, to hold more central bank liquidity and thus counter the tendency of rates to increase.
Basically, going back to the supply/demand approach, the ECB can stimulate demand by lowering the cost of the liquidity it offers, either in a straight way by reducing the official rate or offering for free some optionality attached to the provision of liquidity.
At the end, as I concluded in a previous post, while interest rate control is indeed more difficult for the ECB since it does not control directly liquidity , there are tools which it could use to impose its easing view on the market and thus give teeth to its currently weak forward guidance.
Of course, prospectively demand for another VLTRO could be created when the current VLTROs will expire at the turn of next year: demand for long term funding from the ECB may not have gone to 0 by that time and the ECB may want to satisfy that demand in the framework of its monetary policy. But this is an issue which can be taken at a somewhat leisurely pace over the next few months since it has hardly any effect on current monetary conditions.
[***] Research assistance was provided by Mădălina Norocea.
 See previous posts - "Forward with forward guidance!” OR “Much ado about nothing?" and "Upward bias vs. downward bias: who will win?"