ECB reviews monetary policy framework as Governing Council meets

London

THE European Central Bank (ECB) is starting to consider whether the financial crisis changed forever the way that it controls interest rates.

A decade of pumping cash into the financial system put so much downward pressure on market rates that all policymakers can do is set a floor - the minus 0.4 per cent that they impose for holding banks' deposits overnight. Like the US Federal Reserve and Bank of England (BOE) though, the ECB will need to weigh whether to revert to a system of controlling rates by keeping liquidity tight.

Core to the debate is whether central banks are better off with large balance sheets and far-reaching policy tools, or if they should scale back to avoid crimping money markets. The answers will likely have long-term ramifications for the credibility of monetary policy.

"The size of central-bank balance sheets will never be as it was before the crisis," said Samy Chaar, chief economist at Lombard Odier in Geneva. "It's pretty much a reality now."

ECB staff are already reviewing the monetary policy framework, according to euro-area officials familiar with the matter, who asked not to be identified because the work is confidential. A spokesman for the central bank declined to comment. Executive Board member Benoit Coeure said in a speech last month that the future framework is an important decision "that will need time and careful deliberations".

The ECB's Governing Council started a two-day meeting in Frankfurt on Wednesday to set policy. The explosion in liquidity from stimulus measures so far means that there are now almost two trillion euros (S$4.3 trillion) of excess reserves in the banking system, compared with effectively none before the crisis. The deposit facility sets a floor for market rates because it is the safest place for lenders to park those excess funds overnight.

The ECB, Fed and BOE all previously used a corridor system - so-called because the central bank would manage liquidity to keep short-term rates roughly in the middle of a defined corridor.

The BOE altered its framework in 2009 and now uses the same interest rate for overnight deposits and for its loans to banks.

The Fed switched to a "soggy floor" gradually after 2008. That was because the large non-bank sector - such as asset managers and government-backed mortgage financing agencies that cannot place money directly with the Fed - pushed market rates lower than the Fed's rate on excess reserves. Policymakers introduced another technical tool to soak up that liquidity.

A key argument in favour of the rate floor is that it works with quantitative easing - a tool that could well become a standard feature. Should central banks switch back to the corridor system after shrinking their balance sheets, they could find themselves reversing tack again in a future economic downturn, potentially damaging their credibility.

Fed chair Jerome Powell has said that he "sees the attraction" of keeping the floor, but also that he wants a renewed debate beginning this autumn over how to manage rates in the longer term. William Dudley, before he stepped down as president of the New York Fed, said that the argument for the floor is "very compelling".

A counter-argument was put forward in a 2016 paper by Ulrich Bindseil, the ECB's director general for market operations, who noted that prolonged use of the floor system comes with excess liquidity that can mute lending between banks.

"A lean balance sheet is a sign of well-functioning financial markets and a healthy economy because the central bank is neither used as intermediary by the banking system, nor does the central bank see a need to engage in special crisis measures," he wrote.

There is no need to rush to a decision. As long as excess liquidity remains high - which could be years as the ECB gradually pares back stimulus - market rates will remain largely anchored to the deposit rate.

"The main refinancing operations rate becomes relevant again when the level of excess liquidity is around 250-300 billion euros," said Aila Mihr, an analyst at Danske Bank. "Our view is that that's not going to be reached anytime soon before 2025-26." BLOOMBERG