Rising market rates are posing a dilemma for European Central Bank officials trying to keep their ultra-expansive monetary policy in place.
Overnight borrowing costs for banks have surged above the ECB’s benchmark rate even as policy makers argue that it’s not yet time to exit emergency stimulus. When officials meet in Frankfurt on Feb. 6 they’ll have to assess whether the tighter financing conditions show a resurgence of tensions that warrant a policy response or simply increased confidence in the region’s economic recovery.
ECB President Mario Draghi told business and political leaders in Davos, Switzerland, on Jan. 25 that the central bank will act if it sees an unwarranted rise in money-market rates, which can influence loan costs for companies and households. While banks including Royal Bank of Canada and Commerzbank AG are predicting the ECB will cut its official rates by March, ECB Governing Council member Klaas Knot signaled that assumption is premature.
“Why we are still seeing volatility is a bit of a puzzle for me,” Knot said in an interview at the World Economic Forum in Davos. “I would argue we would need to understand the drivers better before we could come to a conclusion this would warrant policy action.”
The key to any action will be the Governing Council’s interpretation of the “unwarranted tightening” that Draghi said would be one reason to ease policy. It also begs the question of what tools would be best suited to the task, with options ranging from rate cuts to long-term loans.
“We are ready and willing to act if needed,” Draghi said at Davos, where attendees included fellow central-bank heads Christian Noyer of the Bank of France, Jens Weidmann of the Bundesbank, Mark Carney of the Bank of England and Haruhiko Kuroda of the Bank of Japan. Officials are considering “all the instruments that our treaty allows,” Draghi said.
The ECB cut its benchmark rate a quarter point to 0.25 percent in November. The cost of overnight unsecured lending among banks exceeded that level for four straight days through Jan. 21, the longest run since 2011. It climbed as high as 0.36 percent on Jan. 20 from less than 0.1 percent two weeks earlier, before dropping to 0.19 percent on Jan. 24.
The ECB’s key rate will fall to 0.1 percent and the deposit rate, which is currently at zero, to minus 0.1 percent by March, according to Barclays Plc and Commerzbank. RBC says the main rate will be reduced while the deposit rate stays at zero. Alessandro Giansanti, a rates strategist at ING Bank NV in Amsterdam, says the benchmark will be cut within three months.
Knot said officials first need to decide whether market rates have risen because conventional monetary policy is too tight, or because of factors such as a liquidity squeeze that may require a different response.
“If this were to become an issue of the monetary stance, then obviously conventional policy would be the response,” said Knot, who heads the Dutch central bank. “If a need was felt to respond, then it would be logical to contemplate further rate cuts in the main refinancing operations and, in that case, also the deposit rate.”
Liquidity in the financial system has fallen as banks return the emergency three-year loans they took from the central bank in 2011 and 2012. The ECB’s balance sheet has shrunk to 2.2 trillion euros ($3 trillion) from a high of 3.1 trillion euros in 2012. Excess liquidity, or the surplus cash that banks don’t immediately need to meet their obligations, has dropped to 161 billion euros from 813 billion euros.
While falling liquidity can push overnight borrowing costs higher as banks compete for tighter funding, the early repayments may be a signal that banks simply don’t need emergency central-bank cash as confidence returns to the region. That may make the ECB more willing to tolerate rates at current levels.
Surveys of executives and investors point to an improvement in the euro-area economy. Manufacturing is accelerating at the strongest pace in more than 2 1/2 years and economic confidence is at the highest level since July 2011.
“It would need an adverse shock for further action to be taken — at this moment I don’t see such a development,” said Knot. While market volatility “is definitely something that warrants close monitoring,” economic data have, if anything, “surprised on the upside recently,” he said.
Even so, the recovery is “still weak, still fragile, still uneven,” Draghi said, adding that the risks to the outlook remain on the downside. Inflation in the currency bloc slid to 0.7 percent in October and Knot said it will probably stay below 1 percent until May or June, compared with the ECB’s medium-term goal of just under 2 percent. A worsening inflation outlook is another contingency that would trigger policy action, Draghi said.
Officials have other tools that could be used to curb markets rates or stave off falling consumer prices. If the ECB wants to free up more cash that banks could lend to each other or to the real economy, it could remove its requirement for financial institutions to hold reserves at their national central banks. It could also stop the sterilization of government bond purchases conducted under the now-terminated Securities Markets Program.
Draghi told delegates that another option for the ECB to consider is buying bank bonds.
“The issue for further thinking in the future is to have an asset which would capture and package bank loans in the proper way,” he said. While securitization is “pretty dead” right now, this could change if regulators manages to distinguish between asset-based securities that are easy-to-trade and those which are “highly structured,” he said.
Italy’s representative on the ECB’s Governing Council, Ignazio Visco, also signaled that the central bank has a range of options.
“There are assets that can be considered,” for direct purchase in case tensions flare up again, he said in a Bloomberg Television interview.