Mario Draghi’s latest stimulus tool contains a hidden message: If you think interest rates will rise before 2018, take the money now.
The European Central Bank president has offered lenders a fresh round of cash for as long as four years to keep them afloat and make them support an economic recovery by encouraging lending. He’s also inviting bets on when the ECB will scale back its ultra-loose monetary policy -- the more a bank expects borrowing costs will rise over the term, the more attractive the loan looks.
Four weeks after the ECB unveiled an unprecedented plan for boosting the euro area’s floundering revival, economists and investors are still grappling with its intricacy. While Draghi is trying to reassure investors that the ECB will keep policy loose for longer than the U.S. Federal Reserve and Bank of England, the link between the size of stimulus now and the prospect of higher rates later is a reminder that cheap money won’t be around forever.
“Draghi’s latest move has stepped up the complexity of monetary policy, though simpler options exist,” said Andrew Bosomworth, managing director at Pacific Investment Management Co. in Munich. “I’d reserve judgment until we see results from the economy, but if I were trying to make a guess, it would be a 50-50 call whether it’s going to work or not.”
So far, the ECB’s package has prompted a plunge in money markets. Overnight interbank borrowing costs in the currency bloc have averaged 0.06 percent this month compared with 0.25 percent in May. That’s probably enough to stave off further action for now. The Governing Council will keep interest rates unchanged when it gathers in Frankfurt on July 3, according to Bloomberg surveys of economists.
The impact on the broader economy may take longer to materialize. Inflation in the 18-nation bloc held at 0.5 percent in June, about a quarter of the ECB’s goal, according to figures today from the European Union’s statistics office. Lending to companies and households in the euro area fell for a 25th month in May, ECB data showed earlier.
The latest addition to the ECB’s policy alphabet soup -- TLTROs, or targeted longer-term refinancing operations -- as a response to fading price pressures is more than a standard supply of central-bank cash. While banks can borrow funds for two years with no strings attached, and even use them to roll over existing emergency ECB loans, they must prove the money has been lent on to companies and households if they want to keep the funding until the program ends in 2018.
At the same time, Draghi pledged to keep official rates low and extended until the end of 2016 a policy of providing as much short-term liquidity as banks request. That creates a quandary - - determining which funding source is cheapest.
Banks can borrow in the ECB’s weekly and three-monthly operations at the benchmark rate, currently 0.15 percent. While the TLTROs will be priced at a 0.1 percentage-point premium, and so probably cost 0.25 percent in the first round of offers, the rate will be fixed for the term of the loan. The appeal therefore hinges on banks’ expectations for when and by how much the benchmark rate will increase.
“It’s a bit of a conundrum,” said Nick Matthews, senior economist at Nomura International Plc in London. “The program can be interpreted to suggest the ECB could be open to increasing the refinancing rate sometime in 2017, when the actual message and focus should be on the fact that rates will stay low for an extended period.”
Draghi said after the last decision that officials intend to keep rates low for “possibly longer than previously foreseen” and said in an interview published in Dutch newspaper De Telegraaf that the extension of the liquidity policy to the end of 2016 should be understood as “a signal.”
In Bloomberg Monthly Surveys published this month, estimates for the next increase ranged from the first quarter of 2015 to after 2017. The majority predicted a move by late 2016. In contrast, the Fed and the BOE were seen tightening borrowing costs within 15 months.
“The ECB has an interest in telling us now that interest rates will remain low for a while, but that doesn’t mean that their hands are tied for the next four years,” said Holger Schmieding, chief economist at Berenberg Bank in London. “The new loans are built on the premise that interest rates will rise toward the end of 2016. If banks don’t believe that, it’s hardly an attractive offer.”
Under the TLTRO program, financial institutions can borrow money equal to as much as 7 percent of their loans to companies and households, excluding mortgages, in two operations in September and December. That puts the initial size of the program at about 400 billion euros ($544 billion).
Francesco Papadia, a former director general of market operations at the ECB and now chairman of Prime Collateralised Securities in Frankfurt, estimates that the take-up will be less than 300 billion euros. He says the funds will effectively be used to roll over some of the emergency loans issued by the ECB in late 2011 and early 2012 that mature early next year.
In addition, the ECB will make a quarterly offer from March 2015 to June 2016 of 3 euros for every 1 euro of new bank lending. The central bank has yet to spell out the details for that part of the plan.
Bank loans to companies and households dropped 2 percent in May from a year ago, today’s data showed. Lending was unchanged from April. Boosting credit is complicated by the quality of European loan portfolios that the European Banking Authority said last week is still declining.
The crunch has been particularly harsh in debt-strapped countries in the region’s south. Banks there will probably benefit most from the latest stimulus, according to Reinhard Cluse, chief economist for Europe, the Middle East and Africa at UBS AG in London.
TLTRO costs for Spanish and Italian banks could be as much as 114 basis points below equivalent wholesale funding for four years, or as much as 73 basis points for two years, he said. That compares with savings for German lenders of as much as 84 basis points and French ones of 38 basis points.
“It’s a very sweet offer for banks, who on top of taking the money can claim to support the recovery,” said Anatoli Annenkov, senior economist at Societe Generale SA in London. “But I can’t see banks shifting their feet quickly on lending to smaller companies.”
Ultimately, the effect of the program may be hard to detect anyway as the economic recovery slowly strengthens and boosts credit demand, said Richard Barwell, senior economist at Royal Bank of Scotland Group Plc in London.
“Net lending is likely to recover in the next couple of years irrespective of the TLTRO,” he said. That’s “the great irony, and the Governing Council’s potential ‘get out of jail free’ card” when it comes to assessing the success of the initiative, he said.