12. The ECB and Interest Rates

Question 1

The ECB’s original formulation of its monetary policy strategy

Answer 1

the strategy consists of three main elements
(i) a quantitative definition of the primary objective of the single monetary policy, name price stability, and the “two pillars” of the strategy used to achieve this objective
(ii) a prominent role for money, as signalled by the announcement of a reference value for the growth of a broad monetary aggregate, and
(iii) a broadly based assessment of the outlook for future price developments and the risks to price stability in the euro area as a whole”.

Question 2

How the monetary policy strategy changed in 2003

Answer 2

• the medium-term target for inflation was redefined to a value “below but close to 2%”
• the presentation of the monetary policy decisions would start with the “economic analysis to identify short-to - medium-term risks to price stability”
• the monetary analysis would mainly
  serve as a means of cross-checking, from a medium-to-long-term perspective, the indications coming from the economic analysis
• an annual review of the M3 growth reference value was dropped.

Question 3

How the monetary policy strategy changed in 2008

Answer 3

• Full Allotment: Since October 2008, the MRO has been conducted on a fixed-rate basis and all bidders have been allocated their requested amounts of funds. They still to have the eligible collateral to obtain an MRO loan
• Longer Maturities: The weekly MRO ceased to be the major source of funding provided by the ECB, replaced by longer-term financing operations (LTROs) which are loans with maturities of 3 months or above but which in recent years have been up to 3 years
• Looser Collateral Requirements: The list of eligible collateral for all ECB operations has been widened. In particular, starting in early 2012, the ECB widened the amount of “credit claims” (i.e. bank loans) that it will accept as collateral

Question 4

How did the ECB’s “corridor” system affect market interest rates prior to 2008?

Answer 4

• marginal lending facility: loan reserves to banks. In the early years of the ECB, this facility charged an interest rate 1% above the MRO rate
• a deposit facility that paid interest on reserves. In the early years of the ECB, this facility paid an interest rate 1% below the MRO rate.
  These standing facilities are intended to set an interest rate “corridor” for short-term maker interest rates, meaning they set an upper and lower bound for rates.
• since banks can borrow from the lending facility, they do not need to pay a higher interest rate than this in the money market
• similarly, banks don’t need to lend at a rate lower than they can get from the deposit facility.

Question 5

Why the deposit fallacy rate is not the ECB’s key policy rate?

Answer 5

In short, the deposit facility rate is more of a supplementary tool to keep short-term market rates within a target range, while the MRO rate is the primary lever the ECB uses to steer economic conditions in line with its monetary policy objectives.

Question 6

ECB policies prior to 2022 to raise inflation

Answer 6

From about 2014 onwards, the ECB introduced a series of policies aimed at boosting the economy and raising inflation
1. Low interest rates: Setting the MRO rate to zero and setting the interest rate on its deposit facility to negative values
2. Targeted Long-Term Refinancing Operations (TLTROs) incentivising banks to make loans.
3. Forward guidance about the future path of policy
4. Asset Purchase Programmes i.e., the ECB’s version of QE. These programmes involved large amounts of purchases of securities paid for with a huge expansion in the supply of central bank reserves. They were particularly ramped up during the pandemic period.

Question 7

The negative interest rate policy of 2014-2022

Answer 7

From 2014 to 2022, the ECB set a negative interest rate on funds that commercial banks held on deposit with the national central banks. This meant banks needed to pay the Euro system for keeping their reserves with them. And from 2015 onwards, the quantity of reserves increased dramatically due to the ECB’s QE policy.
- this was effective in reducing market interest rates

Question 8

The “reserve tiering” policy of 2019-2022

Answer 8

The negative deposit facility rate was only applied to reserves they held in excess of six times a bank’s reserve requirements

Question 9

ECB policy actions since 2022

Answer 9

The ECB began increasing its interest rates in July 2022, with the deposit rate going from -0.5% to a peak of 4% which was maintained from September 2023 to June 2024
Inflation has declined steadily since late 2022: Year-over-year HICP inflation was 1.8% in September, below the ECB’s target.
While inflation appears back on target, the ECB has been very cautious in reducing interest rates. As of today, the ECB has cut the deposit rate to 3.5%.
ECB seems likely to cut rates further in the coming months but there is little certainty as to where their “ending point” might be.