Eurotower is the name of the building
currently hosting the European Central Bank, waiting to move into its new
premises later in the year, but it is not that the cleaning people in the
Eurotower are not serious about their job: the cobweb I refer to in the title is the one
presented in old microeconomic textbooks.
In the text I studied upon, back in the seventies (Henderson and Quandt, Microeconomic Theory, a mathematical approach), the chart of the stable and the unstable versions of the cobweb, respectively, was presented as follows:
In the text I studied upon, back in the seventies (Henderson and Quandt, Microeconomic Theory, a mathematical approach), the chart of the stable and the unstable versions of the cobweb, respectively, was presented as follows:
Chart 1: Stable (
lhs) and unstable (rhs) cobweb
 |
| Source: Authors' interpretation of cobweb model |
The story was that if supply is a
function of yesterday´s price while demand depends on today´s price (as it
would happen in the production of goods with a long production cycle, like an
agricultural one), then price and supply movements in a chart like the one I
reproduced above would depict a "cobweb" with the stable or the
unstable version depending on the relative elasticities of demand and
supply.
Of course, in more modern text book the
issue would be presented in a much richer way, given the developments that have
taken place in game theory and in the theory of economic expectations since my
textbook was written. Still the original cobweb chart is sufficient to
illustrate a pattern of the relationship between excess liquidity (which is the quantity in the cobweb
chart) and the overnight interest rate (which is the price) that
may be establishing itself in the €-area.
Before I analyse the issue, let me
present the evidence. Chart 2 represents the EONIA and excess liquidity
developments since beginning of November 2013. It is clear that
the two variables have been much more volatile since the second half
of December than before. At the end of last year there was obviously
a reinforced end of year effect, as I argued in two previous
posts. But the volatility
spilled over into the first weeks of 2014.
Chart 2: EONIA and
Eurosystem excess liquidity since November 2013
 |
| Source: ECB SDW, Authors' calculations |
The scatter diagram in Chart 3 however
shows that there has been a (non linear) relationship between the two variables, albeit
pretty noisy, during this period. This should not come to a surprise to those
who have read some of my previous posts [1] in which I illustrated the relationship between excess
liquidity and EONIA. In any case, to be refreshed about the empirical
relationship between the two variables, look again at the long term scatter
diagram in Chart 4, which shows a non-linear relationship between the
two variables, whereby EONIA goes very close to the deposit facility rate
(currently 0) for large amounts of excess liquidity (say higher than 200
billion) while it gravitates around the Main Refinancing Operations (MRO) rate
when excess liquidity is close to zero [2].
Chart 3: Correlation between
EONIA and Chart 4: Correlation between EONIA
and
excess liquidity
since November 2013
excess liquidity since 1999
 | ||
|
The President of the ECB has stressed
in his last Press conferences [3] that, as one can indeed see in Chart 4, the
relationship between excess liquidity and overnight rate is not precise. But a
noisy relationship is still a relationship. And it is not only empirical
observation that tells us that the two variables are connected. The fundamental
equation of interest rate fixation in a corridor approach [4] tells us that when excess
liquidity is very abundant banks know with probability one that they will end the
maintenance period with an excess of liquidity and therefore the only relevant
rate is the one on the deposit facility (currently 0), where they can place their excess liquidity. Before the crisis,
instead, the ECB assured banks that they would end the maintenance period
neither with a surplus nor with a deficit of liquidity and therefore the
probability of an excess or a surplus of liquidity was the same and therefore
EONIA was stable and close to the MRO rate, in the middle of the corridor between
the deposit and the marginal lending facility rate.
The long term scatter diagram in Chart
4 tells us something more than there is a noisy relationship between
excess liquidity and EONIA: it also tells us that the noise around the
interpolating line grows steeply when the amount of excess liquidity moves
below some 200 billion €, as banks have more dispersed expectations about
the liquidity situation that will prevail at the end of the maintenance period.
And 200 billion € just defines the region of excess liquidity which has been
prevailing since December of last year, due to the fact that banks have
returned, particularly in 2013, much of the liquidity they had borrowed under
the two 3 year Longer Term Refinancing Operations.
So to summarise the points so far:
- Excess liquidity and EONIA have been particularly volatile over the last few weeks,
- Still the long term noisy relationship between the two variables, which can be explained in theory and observed in reality, applies,
- At the prevailing level of excess liquidity, the noise around the relationship between the two variables starts to be particularly high.
What I said so far does not justify as yet my "cobweb" story. To
complete the picture you have to recall that it is banks that determine the
amount of liquidity prevailing in the system: since October of 2008, in fact,
the ECB satisfies in full the demand for liquidity of banks, having moved to
fixed-rate full-allotment tenders. Less noticed, until recently, was another
possible source of central bank liquidity in the hand of banks: the non
participation to the weekly operations conducted by the ECB to sterilise the
liquidity created by the purchase of peripheral bonds in the Securities Market
Program, amounting currently to some 180 billion. By non participating to the
operations banks "create" central bank liquidity, as it has happened
recently.
Of course, the demand for liquidity of
banks depends on its cost: when liquidity is cheap they will ask a lot of it,
when it is expensive they will ask less. And the cost must be meant in a broad
sense: 25 basis points, the current cost of liquidity drawn either from
refinancing operations or (in terms of opportunity cost) by non participating
to sterilisation operations, can be very cheap when there are tensions in the
money market that push very high the rate (possibly the shadow rate) at which
banks, particularly from the periphery, could borrow in the market. When
tensions subside, 25 bp can start to be expensive and banks have less
incentives to borrow from the ECB [5]. Indeed, as tensions have substantially come down, the
demand for liquidity from banks has decreased and excess liquidity in the
scatter diagram in Chart 4 has moved towards the "unstable" region below 200 billion. And here comes the "cobweb" pattern: when EONIA is low, banks
draw little liquidity from the ECB (either participating less to refinancing
operations or returning the liquidity borrowed under the two 3 year LTROs or,
still, underbidding at the SMP sterilisation operations) but then EONIA moves up,
possibly above the cost of ECB funding, which then becomes again relatively
cheap and thus recreates an incentive to borrow from the ECB, but then
liquidity increases, EONIA goes down and the incentive to borrow
disappears and… the Perpetuum Mobile of Johan Strauss II is achieved. In short, banks have an incentive to
borrow from the ECB when liquidity is scarce and interest rates are high, but
in so doing they increase liquidity and bring interest rates down.
Sophisticating the analysis and making the behaviour of a rational bank to depend on its expectations rathe than the lagged price doesn't lead to stability: it is profitable to be contrarian and to borrow from the ECB when other banks do not do it and do not borrow when other banks do borrow. But there is no way to know what other banks will do, hence the irregular oscillation up and down of the rate shown in Chart 2. Rational expectations do not solve the issue in this case as they can not settle the indeterminacy between individual and collective bank behaviour.
Sophisticating the analysis and making the behaviour of a rational bank to depend on its expectations rathe than the lagged price doesn't lead to stability: it is profitable to be contrarian and to borrow from the ECB when other banks do not do it and do not borrow when other banks do borrow. But there is no way to know what other banks will do, hence the irregular oscillation up and down of the rate shown in Chart 2. Rational expectations do not solve the issue in this case as they can not settle the indeterminacy between individual and collective bank behaviour.
So, in current conditions, it is not by
chance that the hinge of the yield curve, the EONIA rate, is unstable: there
are systematic reasons for this instability.
If this is the diagnosis, what is the
therapy? What can the ECB do to counter this instability?
I will not explore the theoretical case
in which the ECB would regain control of liquidity by returning to fixed-amount
variable-rate auctions, as it has formally stated that it will maintain full
allotment fixed rate tenders at least until July 2015 [6] .But even leaving to banks the
power to determine liquidity in the €-area, the ECB could counter the cobweb
pattern if this were to continue for too long.
First, it could increase the
outstanding liquidity in the system by stopping altogether the sterilisation
operations, thus injecting, on an outright basis, some 180 billion of liquidity
in the system. This could be reinforced by reducing the compulsory reserve
coefficient, say by a half, thus injecting another 50 billion. This would bring
back excess liquidity well into the area in the scatter diagram of Chart 4 where
EONIA is very close to the deposit facility rate (0 currently). Of course,
over time banks could reduce the amount of excess liquidity by returning larger
amounts of money borrowed under the two 3 years operations and by borrowing
less under the other refinancing operations. Still this would require plausibly
a protracted period of time during which the cobweb would be avoided.
Another solution would be to give
incentives to banks to borrow more liquidity, by making it cheaper. The obvious
way to do this would be to lower the official rate, say from 25 to 10 basis
points. This reduction would also apply to the maximum rate applied in
sterilisation operations and therefore the cobweb pattern would have a more limited range to move.
Lastly, the ECB could find it more acceptable, as it does not require an official change of the MRO rate or an explicit decision to stop sterilisation, to just reduce, say to 10 basis points, the maximum rate of sterilisation operations, meaning that, whenever EONIA would move above that level, banks would have no incentive to participate to sterilisation operations, thus increasing excess liquidity [7]. In a way, bringing down the maximum rate on sterilisation operations to 10 basis points would mean that banks could borrow up to around 180 billion at that cheaper level, thus increasing their demand of liquidity. In current conditions, lowering the maximum rate on refinancing operations would lead to an easing of monetary conditions, even if less than a reduction of the MRO rate would do.
Lastly, the ECB could find it more acceptable, as it does not require an official change of the MRO rate or an explicit decision to stop sterilisation, to just reduce, say to 10 basis points, the maximum rate of sterilisation operations, meaning that, whenever EONIA would move above that level, banks would have no incentive to participate to sterilisation operations, thus increasing excess liquidity [7]. In a way, bringing down the maximum rate on sterilisation operations to 10 basis points would mean that banks could borrow up to around 180 billion at that cheaper level, thus increasing their demand of liquidity. In current conditions, lowering the maximum rate on refinancing operations would lead to an easing of monetary conditions, even if less than a reduction of the MRO rate would do.
Of course, the exit from the excess
liquidity situation will have to be engineered at a certain point in time. But,
as the forward guidance of the ECB made clear, that certain point in time is
still quite far in the future and there will be time to think about the best
way to return to a normal situation.
*** Research assistance was provided by Mădălina
Norocea
[1]See previous posts: Three liquidity scenarios after the year-end and € liquidity is getting more valuable: what can be done about it?
[2] In difference terms, this means that the difference
between EONIA and the MRO rate is zero when excess liquidity is zero while it
is close to the difference between the MRO and the Deposit Facility rate when
liquidity is very abundant.
[3] “(…) let me reiterate once again that it is
very, very difficult to. If you look at the excess liquidity recorded on 19
December 2011, you will see excess liquidity standing at around €300
billion and the EONIA at 57 basis points. Let us then move
to 15 May 2013: excess liquidity was €303 billion, i.e. roughly the
same amount as on 19 December 2011, but the EONIA was only 8 basis
points. It is thus very, very difficult to draw the conclusion that there
is a stable relationship between the two variables.”, Mario Draghi, Press
conference, 9th of January 2014
[4]
[5] The latter phenomenon is arguably reinforced by the fact that the stigma effect implicit in borrowing from the ECB increases the total cost of drawing liquidity from ECB operations
[6] " (...)we decided today to continue
conducting the main refinancing operations (MROs) as fixed rate tender
procedures with full allotment for as long as necessary, and at least until the
end of the 6th maintenance period of 2015 on 7 July 2015" Mario
Draghi, Press conference, 7th of November 2013
[7] This approach was suggested to me in a conversation with Brian Sack, my former counterpart at the New York FED, who is now at the D. E. Shaw Group.
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