The Zhitong Finance APP has learned that officials from the European Central Bank are weighing whether they have raised borrowing costs sufficiently, and they are facing a related challenge: how to ensure that their policies continue to work. European Central Bank President Christine Lagarde and her colleagues are seeking to repair the pipeline connecting the European Central Bank and major banks, as constantly shrinking balance sheets may distort policy transmission. The models of the Federal Reserve and the Bank of England provide options, but this does not necessarily mean a simple solution.
Fifteen years ago, the bankruptcy of Lehman Brothers marked the arrival of the era of unconventional liquidity tools - ultimately confirmed by central banks, including the European Central Bank, as quantitative easing.
The officials of the European Central Bank cannot turn back the clock, they can only rebuild the money market system that has become a thing of the past. But without thorough reform, the European Central Bank's current total bond holdings of 5.3 trillion euros (approximately 5.6 trillion US dollars) and long-term loans, once fully released, may ultimately distort its monetary policy mechanism for combating inflation.
The solutions attempted by other central banks have provided some inspiration, but there are no simple templates or solutions for reference. Therefore, after making a temporary decision to raise interest rates again in September, European Central Bank officials had to carefully consider the overall functionality of their monetary framework. This is not a trivial issue, "Lagarde told lawmakers last month, adding:" It will tell us the most suitable balance sheet size
Policymakers at the European Central Bank hope that ECB staff can rethink the relationship between the ECB and the European financial system, and thus the economy itself. Lagarde promised to release the results in early 2024. The following are the main challenges that the European Central Bank may face, as well as possible reference practices.
Huge balance sheet
One of the top tasks for officials at the European Central Bank is to shrink the constantly expanding balance sheet since the 2008 global financial crisis, a process that will contribute to monetary tightening itself and create greater space for potential asset purchases in future crises.
This will also put the European Central Bank on a path that could return to providing large-scale liquidity operations over the years, as well as entangle it with government finances through bond purchases and change the banking background that existed before the possible return to the framework.
But reducing the balance sheet actually means freeing the financial system from dependence on ample liquidity from the central bank. However, this is not easy, as it is the norm that major financial institutions have become accustomed to. Therefore, officials need to study how to ensure smooth operation and avoid impacting the entire financial market.
Providing huge funds to major banks
When the European Central Bank began providing unlimited liquidity support to all banks in 2008, it marked the end of a world where banks relied on mutual loans instead of relying on central banks to provide liquidity; Policymakers in the previous world strictly controlled the amount of money in the system to guide market interest rates within a corridor. Subsequently, large-scale bond purchases permanently closed this system.
In the end, many central bank officials still dream of recreating the pre crisis environment, despite concerns that institutions may have lost the know-how and expertise to operate in such an environment.
Policymakers themselves have also lost a concept called "visibility". They may want to know what funds the banking system needs, but it's not easy to know. Due to stricter regulation and a preference for additional buffering, demand is definitely higher than before. The potential introduction of the digital euro, although it may take several years, will also have a certain degree of impact.
A report commissioned by the European Central Bank estimates that European banks will need approximately 1.4 trillion euros in reserves to maintain the comprehensive operation of the financial system. Bloomberg Economics believes that the size of the base currency is expected to be between 1.8 trillion euros and 2 trillion euros.
Flow faucet
The current framework forcibly injects liquidity into the European financial system and sets a lower limit indicator for borrowing costs, rather than attempting to manipulate interest rates with the upper limit, known as the "corridor" system.
The excess liquidity of the European Central Bank is slowly shrinking
This supply driven approach cannot ensure that sufficient cash is evenly distributed in every corner of the eurozone, which means that the possibility of financial tightening cannot be ruled out.
European Central Bank officials are studying whether this is still the best option. The Federal Reserve has promised to maintain a similar framework, but this means maintaining a larger balance sheet for a long time.
UK approach
Some officials, including Isabel Schnabel, a member of the Executive Committee of the European Central Bank, are eager to transition to a model similar to the Bank of England's demand driven approach, which also uses bottom price fixing measures to manipulate interest rates.
Although the Bank of England also has a bond investment portfolio, its framework relies on banks borrowing the funds they actually need. Due to the matching of the interest rate for providing funds with the deposit rate of the Bank of England, excessive borrowing can be said to have no cost.
This system allows for a more streamlined balance sheet than the Federal Reserve, without the risk of liquidity tightening or reserve imbalance. An important advantage of the European Central Bank is that it can release high-quality collateral and allow them to re-enter the market.
It can also enable policymakers to learn from the behavior of banks and better estimate funding needs - which may be a way to rebuild the past tight monetary system.
But imitating it requires some changes. Although the European Central Bank already has the necessary mechanisms to provide loans to banks, officials need to eliminate the interest rate difference between banks' overnight lending rates and cash acceptance rates, or, like the Bank of England, permanently provide loans at rates equal to deposit rates. This will to some extent convince major banks that using this mechanism will not be seen as a sign of economic weakness.
Public data shows that unlike the Federal Reserve and the Bank of England, which only regulate a single benchmark interest rate, such as the Federal Funds Rate, the European Central Bank needs to regulate three major benchmark interest rates: the main refinancing rate, the marginal lending rate, and the deposit mechanism rate.
Looking back on 2008
If the European Central Bank ultimately wants to rebuild the pre crisis system, it must limit the amount of funds provided to eurozone banks. In this case, due to a decrease in freely available funds, overnight market interest rates will rise as banks will pay higher interest rates for increasingly scarce liquidity.
This will re-establish the main refinancing rate - the rate at which banks can borrow - as the benchmark. Its existing two other interest rates - deposit rate and marginal loan rate - will serve as the roof and ceiling of this corridor.
I miss this corridor a bit, "Francesco Papadia said. He was responsible for market operations at the European Central Bank from 1998 to 2012 and is currently a senior researcher at the Bruegel Institute. This may once again become the situation we want. But at this stage, I cannot make a commitment
The Riksbank of Sweden is attempting to quickly establish interest rate corridors by absorbing excess funds from the banking system, but this is still an ongoing work. Officials are working hard to attract sufficient demand, so the market benchmark interest rate is still closely linked to lower deposit rates, rather than the official policy interest rate of the Swedish central bank.
Such a corridor system is also not easily compatible with the resumption of quantitative easing in future crises, as the generation of excess liquidity will push borrowing costs back to the lowest level.
Work in progress - reducing the table
No matter what decisions the policymakers of the European Central Bank make, time is passing. Of the 4.8 trillion euros in bonds held by the European Central Bank, approximately 333 billion euros (approximately 7%) will roll off the balance sheet by September next year. The target long-term loan of 491 billion euros will expire by the end of 2024.
Senior researcher Francesco Papadia said, "It is expected that our balance sheet may return to normal by 2028 or 2029." "Until then, it is unlikely that there will be anything different from flooring methods. I believe that the question of the optimal framework can only be answered in the future, but it would be good to start discussing this issue now