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The European Central Bank on Thursday announced its expected increase in the official deposit rate by 75 basis points to 1.5%. But the decision came with a dovish bias acknowledging the deteriorating growth outlook and an attempt to prevent banks from benefiting from the rapid shift in monetary policy seen in recent months. More than ever, policymakers are fighting on multiple fronts at once.
President Christine Lagarde stressed that the economic slowdown in the euro zone’s third quarter will deepen into next year. While she said several more hikes were possible to fight double-digit inflation, traders reduced their expectations for December’s move to just 50 basis points. This month will also see discussions about future ways to reduce the central bank’s €5 trillion ($5 trillion) balance sheet. In other words, quantitative tightening is not coming this year.
However, raising interest rates and halting bond purchases are the easy parts. Keeping the money flowing freely through the pipelines while tightening up policies is more complex.
The ECB has lent around €2 trillion in super-cheap loans to the banking system over the past decade. Known as targeted longer-term refinancing operations, some were offered at interest rates as low as minus 1% at the height of the pandemic. The original premise was to encourage increased bank lending to businesses, particularly in peripheral countries. However, large amounts were invested in government bonds, with Italian banks being particularly active.
But this generosity, much-needed at the time, has quickly become a hot political issue. Put simply, the banks can take the free money and pay it back at the central bank at the new, higher interest rates. So TLTRO conditions are tightening and the ECB seems determined to end the program as soon as possible.
The banks are given three windows in which they can repay the loans early. And to give them an incentive, rates on all outstanding loans will rise to the current deposit rate of 1.5% from November 23. On average, this means an increase in financing costs of between 200 and 250 basis points. With the deposit rate likely to rise further to 2% at the December 15th meeting, this will encourage virtually all banks to exit the program by the end of the year. Only banks that cannot finance on attractive terms and need longer-term loans are likely to hold these loans.
Taking away liquidity always comes with risks, as pulling on one end of a string can unravel unexpected things. Banks could respond by restricting lending to businesses and households, further dampening growth. Or they reduce their holdings of government bonds while the ECB tries to reduce its mountain of debt. If the central bank miscalibrated, the law of unintended consequences could kick in. Financial conditions are tightening rapidly anyway, with the deposit rate soaring from minus 50 basis points just three months ago.
The other risk of liquidity deprivation is leading to a collateral squeeze in the bond market, which UK gilts have recently suffered from. In a positive interest rate environment, the deposit rate of the ECB should represent the lower limit of the monetary policy framework; However, market interest rates can sometimes drop below the official rate as financial institutions desperate for quality collateral and offer more attractive financing rates to secure valuable assets. Lagarde said the central bank is well aware of this risk, noting it could become even more of a problem by the end of the year; She also said that changing TLTRO’s terms should “increase the pool of collateral going forward.”
“We’ve made progress towards normalization, but we still have work to do,” Lagarde said. The ECB became the party to rate hikes later than its rivals at the Federal Reserve or the Bank of England; But by focusing on the cost of credit rather than the balance sheet, the company has given itself some much-needed breathing space to weather a slump in growth if it hits this winter.
More from the Bloomberg Opinion:
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• Fed pullback? Not if you watch the bond market closely: Conor Sen
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Markets Strategist at Haitong Securities in London.
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