Guessing ECB liquidity until the first Targeted Longer Term Refinancing Operation

The position of money market rates in the €-area within the corridor recently set by the ECB (-10 to + 15 basis points) depends on the outstanding amount of excess liquidity demanded by banks, and is thus not under the direct control of the ECB. It is thus useful to try and guess what excess liquidity could do between now and the first Targeted Longer Term Refinancing Operation (TLTRO) in September. In principle one could follow either a bottom up or a top down approach to carry out this exercise.

A fair chance for the European Central Bank

In a couple of tweets I published on the occasion of the last press conference of the ECB president on June 5th, I gave my first assessment of the package of measures decided by the ECB: not overwhelming. Overall the market seemed to share this assessment as the exchange rate hardly moved while short term rates (Euribor, OIS and Bubills) only came down in a limited way (Chart1). 

An enticing Very Long Term Refinancing Operation from the ECB

Since the last press conference of the ECB President, several members of the Governing Council have confirmed that the ECB is preparing a package of measures to be decided at the next meeting of the Governing Council. I have given my sense of what could be the content of this package, as well as its interest rate consequences, in a previous post [1]. In a more recent Tweet I have increased the probability, up from 60 per cent, of a negative deposit rate being part of the package.

Where could ECB interest rates go?

A quasi announcement

Economics is mostly quantitative, being dominated by mathematics in its theoretical framework and by econometrics in its empirical one. Central banking seems instead to be dominated by a literary approach. In July 2012 the “Whatever” utterances by Draghi contributed to change the path of the € crisis. In the last press conference, his statement about the Governing Council being “comfortable” in acting at the subsequent policy meeting sent a clear message that the ECB convinced itself, not too early in the view of about everybody else, that something had to be done to counter the gradual dis-anchoring of inflationary expectations [1]. 

Is the ECB really so generous?

A simplified, to the point of being simplistic, approach to understanding the transmission of monetary policy to the real economy consists of three basic links:

1. The central bank fixes, or at least strongly influences, the marginal cost of bank funding through its interest rates;
2. Banks equalise the expected marginal cost of their own funding to the marginal revenue from lending;
3. Firms, households and the external sector, in the latter case through the exchange rate, increase or decrease aggregate demand, and ultimately prices, in line with the cost of bank lending.

Titus Maccius Plautus and the EU Troika

The Roman comic playwright Titus Maccius Plautus takes up an old adage of Greek origin when he writes in his Bacchides: "Quem di diligent, adolescens moritur", which translated into English sounds: "Whom the gods love die young". This is of course a paradox: the empirical proof that gods do not make a favour to those they love by making them die young is the fact that large shares of national income are devoted to maintaining or regaining health, in view of a long life. But, taking the same paradoxical line as Plautus, I am tempted to say: "Happy the countries that had the troika!"

Some unpleasant Quantitative Easing Arithmetic

Some 30 years ago Thomas Sargent and Neil Wallace published an article [1] that raised the possibility of tight monetary policy leading to inflation. Salvatore Rossi and I showed that this result was due to a questionably formulated public budget constraint in their model [2] and basically salvaged the traditional result that it is loose monetary policy that leads to inflation.

The link between that old story and Quantitative Easing is that there is something unpleasant about Quantitative Easing arithmetic, at least for those market observers that, with some justification, interpret recent ECB message as pre-announcement of some exercise of this sort.

Is the €-area in 2014 like Japan on the dawn of deflation?

If you are impatient and somewhat trust my judgment, let me give first my synthetic answer to the title question: out of the five criteria I use to compare the current situation in the €-area to that in Japan at the end of the ´90s, two (current situation of the banking sector and inflationary expectations) do not indicate that the €-area is in a better position than Japan when it was about to enter its deflationary period. On one other criterion (central bank activism) there is a slight advantage for the ECB. On the two last criteria (the prospective cleaning up of the banking sector and demography) the situation in the € area is clearly better than it was in Japan. Overall, my sense is that, in particular taking into account the recent hesitations of the ECB to confront too low inflation, confirmed in the last press conference, and the now weakly anchoring of inflationary expectations, one cannot exclude a significant risk of Japanification for the €-area.

Partiam, partiamo or the ECB communication

In the "Atto secondo, Scena IV" of Verdi`s opera, La Forza del Destino, there is a famous choir which keeps singing "partiam, partiam, partiamo" (let's leave, let's leave, let's leave) while remaining stubbornly on the scene, without making deeds follow words.

I cannot help recalling this scene while observing the communication from the ECB.

It is a few months, since November of last year when it last reduced rates, that the ECB is sending the message that it is ready to reinforce its action to symmetrically pursue its objective of "close but lower than 2.0% percent in the medium term", while not actually following up with action.

From firmly to weakly anchored, or the importance of an adverb!

Four months ago I published a post with the title: Is the price stability target of the ECB at risk? In it I explored the risk of inflation remaining too low for too long in the €-area.

My conclusion was: ”yes, there is a risk for the price stability objective, but the probability of this unfavourable development is low if the ECB will use its tools appropriately.” In light of the lack of action by the ECB in March, even when projecting inflation remaining well below its objective of “close but below 2.0% in the medium run” for the fourth year, it is useful to review the issue and update the answer.