On Thursday May 2nd, the Governing Council of the ECB will hold is monthly meeting to determine the path of monetary policy. The market consensus seems to be that the ECB will cut the refi rate (MRO rate). I disagree. In my opinion, the ECB has repeatedly stated that it believes the channel of monetary policy transmission is still broken and that unless it is fixed monetary policy is not able to lift the Euro-Zone economy. The data also seems to imply that banks’ reliance on ECB liquidity has decreased considerably, so that the direct effect of an EONIA cut is very limited. I also believe that the ECB is aware of the limited indirect impact that an MRO cut would have on EONIA, the interbank market and the willingness of banks to lend. Last but not least, nothing of what I am hearing from the ECB is making me think that they believe a cut is the way to go. Here’s the fine detail:
Everyone Foresees an ECB MRO Cut
Apparently a majority of the 69 economic professionals polled by Bloomberg expects the rate to fall to 0.5%. As far as I can tell, at least Danske Bank, BNP Paribas, Deutsche Bank and KBC share this forecast, while Unicredit appears to expect this to be postponed to June.
The logic is clear. The economy is contracting, broad money is decreasing at the expense of base money and inflation is now below the 2% target of the ECB. Given that there is no reason to be affraid of low interest rates, why not lower it? (goes the argument)
Of course, as you might have guessed, I find this argument somewhat flimsy… Here’s why:
The Problem: Deleveraging, its Drivers and the Broken Channel of Monetary Policy Transmission
3 related trends have broken the channel of monetary policy transmission, making monetary policy inefficient. First there’s a deleveraging readjustment of European sovereigns, caused by the fact they they were too profligate in the past. Not possessing enough savings nor being particularly strong exporters, these countries relied on abundant money generated by securitisation and sequential collateralisation to fund a quality of life that was beyond their productive ability could not afford (independently of my opinion about the quality of the reactions to the crisis). Then there’s the banking connection. Due to the devaluation of government bonds, banks’ balance sheet took a hit. At the same time, the bursting of several other asset bubbles, most prominently real estate, reinforced this balance sheet contraction. Thirdly, Basel III is meant to limit banks’ liquidity problems thus requiring them to hold easy to sell and understand assets like prime rated government bonds, instead of dubious mortgages and credit to SMEs.
As a result, there is less money and less willingness to share it. As a result, banks want and have to lend less than prior to the crisis. Superficially, this reflects itself in the evolution of M3 described above and decreased volumes of interbank loans.
What M3 and EONIA volumes hide is a wide divergence between the core and the periphery, caused by core banks considerably decreased their exposure to the periphery. This choice broke the channel of monetary policy transmission. It meant that peripheral banks were largely unable to fund in the interbank market from their core competitors, who preferred to stash their cash at the ECB.
This created two Euro-Zones and forcing the ECB to intervene to ensure that illiquidity would not turn into systemic banking insolvency, creating the intra-Eurosystem Target2 imbalances that have become the face of a broken channel of monetary policy transmission.
An MRO Cut Will not Fix the Channel of Monetary Policy Transmission
The problem with the argument that predicts an MRO cut is that it fails to take account of this conjuncture and presumes that lower MRO rates automatically lead to more consumption from households and/or investment from businesses, rather than the sovereign debt crisis. However, the problem does not necessarily seem to be high funding costs, although clearly some pay more than others. Indeed, the main concern seems to be the lack of available good credit to which to lend funds rather than the sovereign debt crisis. This may be a chicken and egg situation, but it seems to me that in this context, the trigger for any policy shift is better found within bank lending surveys than in inflation data.
Limited Bank Reliance on MRO
A cut in the MRO rate would only directly assist markets to the extent that it would allow banks to borrow more cheaply from the ECB at a weekly maturity. However, when we look at the volumes of MRO as provided by the ECB to banks, we can see that bank reliance on the MRO channel has vanished.
Most of the cash shifted to the LTRO, whose relevance is still quite large although slowly fading away.
How it works: MRO Cuts, Deposit Facility Constraints and EONIA Rates
Traditionally speaking the MRO is the interbanking target of the ECB, which means that a rate cut of the MRO is meant to make funds cheaper as measured by EONIA, but also EURIBOR, EUREPO and EURO-SWAP. However, since 2009 and the change from a variable rate/pro rata allotment to a fixed rate/full allotment of MRO funds at auction, the Deposit Facility has been the benchmark of the interbank market. As a result, cutting the MRO serves no purpose. At the same time the deposit facility is at the zero lower bound and unless the ECB intends to go into negative rate territory, there is nothing it can do to affect EONIA.
Opinions of ECB Governing Council Members
People expect something from the ECB because Draghi has hinted in this direction, when he said that
This gross extrapolation, from an otherwise relatively general statement, was reinforced when Weidmann confused people by opening the door to a rate cut, before shutting it down relatively soon after the markets reacted by devaluing the EUR.
Instead, the focus at the ECB seems to be on the SSM. As the ECB’s Benoit Coeure put it recently,
“The Single Supervisory Mechanism will contribute to restore the singleness of euro area banks’ liabilities provided that it is complemented by a single mechanism, with a common financial backstop, to wind down failed banks“
To this general view, the ECB’s Vice-President, Vitor Constancio added that the importance of confidence in the health of the banking system would be reinforced by the SSM’s balance-sheet assessment that will be conducted before actually starting supervision.
On top of this assessment, the ECB’s focus seems to be on new forms of unconventional policy such as assistance to SMEs. On this topic, Mersch has referred to an old Italian Asset backed purchases and the a potential role for the EIB and other development banks.
That being said, the argument is not very convincing and the ECB still seems to be concerned by the direct and indirect risk that asset purchases or funding for lending would impose on the ECB’s balance sheet.
In conclusion, I don’t think that the ECB is going to lower the MRO anytime soon.In my opinion, the ECB believes that the channel of monetary policy transmission is still broken and that unless it is fixed monetary policy is not able to lift the Euro-Zone economy. The data also seems to imply that banks’ reliance on ECB liquidity has decreased considerably, so that the direct effect of a EONIA cut is very limited. I also believe that the ECB is aware of the limited indirect impact that an MRO cut is would have by impacting EONIA, the interbank market and the willingness of banks to lend. Last but not least, nothing of what I am hearing from the ECB is making me more think that they believe a cut is the way to go. Of course I could be wrong.
In light of the aforementioned facts I believe that if the ECB does so, it will only be for the purpose of satisfying analysts’ confirmation bias. Whether this would be very wise is dubious to me. As a matter of fact such a move would strike me as rather desperate, in which case markets may want to worry a little bit.
My opinion is that any decision on MRO rates is conditional on fixing the channel of monetary policy transmission. Although the pieces are not yet there, I suggest you go back to the graphs and check how deposit facility holdings, the current account holdings, MRO and LTRO are desirably falling while EONIA volumes have recently edged up. As it appears, these have been moving in the right direction without any assistance by the ECB. Indeed, the adjustment is most likely to be structurally driven by deleveraging and qualitative balance sheet realignments. At the pace at which things seem to be moving, and assuming the pace is maintained, it seems to me that in 6 to 9 months, those variables will normalise to pre-crisis levels. If at that stage, the economy is still contracting, the ECB will probably be desperate enough to lower interest rates even though the technical reasons why this would be irrelevant will still hold. Any move at a earlier time will only signal premature panic the uselessness and sycophantism of which should worry markets.