It’s time to address the monetary policy elephant in the room
Taken by surprise by the resurgence of inflation, the European Central Bank started raising rates last summer and is still in the process of doing so. At her press conference on 16 March, President Christine Lagarde started her remarks with: ‘Inflation is projected to remain too high for too long.’ She then announced a 50 basis point increase in interest rates, the seventh in a row.
This firm stance, after a week of tremors in the global banking sector, was supported by an overwhelming majority of governing council members; only ‘three or four’, she said (out of 26), did not support her proposal. This was a remarkable demonstration of consensus and resolve by a very large committee.
Out of the spotlight, meanwhile, there is a huge elephant in the monetary policy room: the central bank’s balance sheet. Years of massive expansion have deposited a staggering €4tn of idle liquidity in the pockets of euro area banks. Until that stash of cash goes away, the ECB can only raise rates by subsidising the deposits it receives from banks. The remuneration on its deposit facility was raised from minus 0.5% last July to 3%, on a riskless basis. It will probably go beyond that. This is a hefty subsidy to bank shareholders: except for them, nobody today can access a risk-free rate of 3% in the open market.
This is a dangerous course. The assets the central bank holds against these deposits yield returns far below the funding cost. Calculations by Daniel Gros, a senior fellow of the Centre for European Policy Studies, show that this is enough to wreck the accounts of the ECB and its constituent national central banks in the years ahead. Bundesbank President Joachim Nagel must have felt some embarrassment recently as he announced to the German public that the losses of the German central bank last year are not covered by provisions. This is an accounting euphemism to say that the central bank may need financial support from the government, and indirectly from the national taxpayer.
Economic textbooks say that central banks cannot go bankrupt, but this is another euphemism. It is easy to think of situations where the central bank and the money it issues – the euro in this case – loses support and reputation among public opinions and political circles, some of which in Europe edge towards populism. When this happens, the loss of central bank independence is just around the corner.
The only way for the ECB to stay clear of danger is to keep its deposit facility rate low. But this is compatible with the intended monetary policy course only if the bank liquidity and the central bank’s outright portfolio of securities – two amounts which are roughly equivalent – are reduced in parallel, and fast. The ECB has started scaling down its securities holdings at a pace of €15bn a month on a net basis. This is not sufficient. Other things being equal, it would take some 27 years to reabsorb all the liquidity that is around through this channel alone. The ECB cannot afford to wait that long.
One way to accelerate the process is to re-activate a long-term liquidity-management instrument introduced by the ECB in 2014, the so-called ‘targeted long-term financing operation’, but in reverse. The new reverse long-term operation would auction out rights to swap central bank deposits for long-term securities on a long-term basis according to the maturity of the bonds. Auction participation would be voluntary but incentivised. Banks deciding not to swap out their central bank deposits would be penalised by a lower deposit rate. Swap rights could be calibrated by taking into account the balance of each bank at the deposit facility.
Calculations suggest that an auction mechanism so designed would induce profit-maximising banks to swap away large amounts of their deposits in exchange for temporary (but long-term) government bond holdings.
Regardless of the specific mechanism chosen, one thing is clear: a coherent package of measures and incentives lowering the deposit rate and reducing bank liquidity alongside the central bank’s portfolio is the only way the ECB can maintain monetary control and salvage, together with its own accounts, its operational flexibility and independence. The issue is urgent. Most national central banks of the euro area will soon present their accounts for 2022. At that time, the monetary policy elephant and its impact on European taxpayers will be apparent. The ECB would be better off having answers when this happens.