Rising inflation since 2022 has resulted in the European Central Bank adopting a more restrictive approach to monetary policy. Yet as Angelo Baglioni explains, years of quantitative easing mean there is still a huge amount of excess liquidity in the eurozone.
Prior to 2022, when a sharp rise in inflation occurred in the eurozone, the European Central Bank (ECB) had been implementing an ultra-expansive monetary policy, often termed “quantitative easing”. A huge surplus of liquidity was created through securities purchases and long-term loans to the banking sector, flooding banks with financial resources that are deposited at the central bank itself.
While the ECB has now adopted a more restrictive approach in reaction to the surge in inflation, it remains an open question what will happen to the liquidity that is still around in the eurozone. Will there be a return to a shortage of liquidity, as occurred before quantitative easing? Or will this surplus of financial resources remain in the banking system?
Interest rate steering and the new normal
The question is relevant not only for the banking sector, but also for the fate of the large portfolio of government bonds held by the European Central Bank and the national central banks of those countries that have adopted the euro (often referred to collectively as the “Eurosystem”). An abrupt return to the approach that existed prior to quantitative easing would imply a quick disposal of this portfolio, which would be extremely problematic. For this reason, any downsizing of the balance of the Eurosystem is likely to be slow and partial.
To understand this, let’s take a step back. Before 2007, most central banks used to follow the “interest rate steering” approach, where the operational target of monetary policy was the level of interest rates in the money market and this target was implemented by an active management of bank reserves (i.e. the money deposited at the central bank by commercial banks), in presence of a structural liquidity shortage.
By announcing a target level for the overnight interest rate and by managing the supply of reserves, central banks were able to keep the market overnight rate in line with the level consistent with their strategic decisions. When the level of interest rates hit what is called the “zero lower bound”, many central banks adopted the quantitative easing approach, under which the operational target was the size of the central bank balance sheet. Quantitative easing policies implied the injection of huge amounts of liquidity into the money market. The structural excess of liquidity made the market overnight rate stick to the floor provided either by the zero lower bound or by the rate paid on bank reserves by the central bank: this is why this approach is often referred to as the “floor system”.
The exit from quantitative easing policies and the normalisation of monetary policy over the last two years have led some major central banks to adopt a “new normal” that combines some features of the interest rate steering approach with others deriving from the quantitative easing experience. Under this new approach, the level of interest rates is again the operational target of monetary policy. At the same time, the new normal relies on the floor system: the market for bank reserves features a structural excess supply and the equilibrium level of the market overnight rate coincides with the interest rate paid on reserves.
Should the ECB follow the example of other central banks?
The ECB is currently implementing its policy within an excess liquidity framework, but an official decision has still to be taken: the current review of its operational framework is expected to provide an outcome by spring this year. There are good reasons to believe that the “ample reserves regime” (using the terminology of the US Federal Reserve) is superior to the old interest rate steering framework and that the ECB should follow the example of other central banks.
Such reasons can be briefly summarised as follows. First, the ample reserves approach gives central banks one more degree of freedom, since the interest rate policy and the balance sheet policy become two independent instruments that can be targeted to different objectives. This property, that does not hold under the traditional interest rate steering framework, is particularly relevant in the eurozone, where the interest rate policy can be used to set the stance of monetary policy while the balance sheet policy can be used to address any potential fragmentation of financial conditions across member countries.
Second, the ability of the central bank to keep the market overnight rate in line with the announced target level is stronger in the floor system than under the interest rate steering approach. The latter relies on the ability of the central bank to forecast the daily liquidity needs of the banking system, to be matched by the active management of the supply of bank reserves. Such forecasts are subject to errors due to liquidity shocks, introducing undesired volatility of money market rates. In contrast, liquidity shocks do not have any impact on the money market rates in a floor system, where they are absorbed by the “buffer” provided by the structural excess supply of reserves.
Finally, given the current size of the excess liquidity in the eurozone, a return to the scarce reserves regime would require a strong acceleration of the “quantitative tightening” currently taking place, implying a sharp downsizing of the Eurosystem’s securities portfolio. The deposits of the eurozone banking system with the central bank (in excess of the required reserves) amount to over 3.5 trillion euros. Even if we consider that 400 billion euros of this excess liquidity will be reabsorbed in the coming months through the repayment of outstanding long-term loans, 3.1 trillion euros remains to be reabsorbed.
A need for clarity
At the current rate of repayment of maturing securities purchased under the ECB’s Asset Purchase Programme (around 300 billion euros per year), it would take about ten years to reabsorb the excess liquidity. The securities purchased under the Pandemic Emergency Purchase Programme must also be added to this equation: from July this year, this portfolio will be reduced by 7.5 billion euros per month and the reinvestment of maturing securities will be completely discontinued at the end of this year. These calculations, although approximate, give us an idea of the effort needed to reabsorb the excess liquidity accumulated over the past few years through quantitative easing.
One way to accelerate this process could be to raise the minimum reserve requirement ratio, currently at 1%, thus leading to a greater absorption of base money through this instrument. Assuming the reserve requirement continues to be unremunerated, as has been the case since last September, this route would help reduce the interest payments from the Eurosystem to the banking sector, currently estimated at 140 billion euros annually. All the above arguments suggest that, at the end of the current review, the ECB should officially confirm what its operational framework will be.