ECB staff preparing for new era of tighter money, sources say

Senior European Central Bank staff are meeting in Helsinki this week to work on a new framework for steering short-term borrowing costs, another step towards ending nearly a decade of easy money, five sources told Reuters.

The meeting of the Market Operations Committee, made up of staff from the ECB and the euro zone’s 20 national central banks, comes as ECB policymakers gather in Sintra, Portugal for an annual forum hosted by the central bank.

In Finland, staff will consider how the ECB should operate now that inflation and interest rates are high and efforts to curb price growth are being impeded by over 4 trillion euros of excess liquidity sloshing around the banking system – the legacy of a decade of crisis-fighting stimulus.

The committee will work on how to prepare for a scenario in which liquidity is less abundant, meaning that banks will need to borrow cash from the ECB, as is already starting to happen, to finance their own lending.

The debate includes deciding how to remunerate banks for their minimum and excess reserves, two of the sources with direct knowledge of the discussions said.

An ECB spokesperson declined to comment.

At present, minimum reserves are remunerated at the ECB’s deposit rate, now 3.5% after a string of interest rate hikes to tame inflation.

Some policymakers have argued the deposit rate should be set at zero on mandatory reserves, saving central banks billions of euros in interest they are currently paying out to commercial lenders but potentially blunting the impact of rate hikes.

Excess reserves would still be remunerated at the deposit rate.

RATES CORRIDOR

The five sources said staff will also go through options for adjusting the “corridor” between the ECB’s three interest rates and prepare for a review promised this year of the broader operational framework.

The ECB currently pays banks 3.5% on their deposits while lenders can borrow from the central bank at interest rates of 4% for a week – the main refinancing, or refi rate – or 4.25% overnight.

Reducing that asymmetry is seen as a first step, although policymakers have so far rejected any move as premature, the sources said.

Potential fixes include raising the deposit rate to create a narrower corridor, or moving the overnight rate to make the corridor wider, although neither option is seen as problem-free, the sources said.

A wide corridor could be seen as penalising borrower banks compared to those which have excess liquidity to deposit at the central bank.

Skipping a hike in the refi rate, which was the ECB’s benchmark for years and is still seen as such by many euro zone citizens, could meanwhile be portrayed as complacency given inflation is over three times the ECB’s 2% target.

The sources said some staff advocate leaving an adjustment of the corridor until the ECB ends its current tightening cycle, with the final move a change in the deposit rate.

But with many of the ECB’s past projections having proved wrong, policymakers are unlikely to have full confidence that any move will be their last. The central bank has already promised a July rate hike and markets see a significant chance of further move in September or October.

A decision on the corridor is unlikely to come in July but may be on the agenda after the summer break, the sources said.

BALANCE SHEET

A second debate, on how the ECB’s balance sheet will function as liquidity drains out of the system, is potentially more significant but less urgent, the sources said, as it may be years before banks need to regularly borrow cash from the ECB.

The ECB has given itself a year-end deadline to decide, the sources said, although details could take longer to work out.

Now, the deposit rate effectively sets an interest rate floor, similar to the way U.S. Federal Reserve rates function and the sources indicated this was likely to remain the case.

The question is how much excess cash should remain in the system.

A paper being presented at this week’s Sintra forum argues that the ECB could shrink excess liquidity from 4.1 trillion euros to between 521 billion and 1.4 trillion euros. It has already reduced its balance sheet by over a trillion euros from a peak reached last year.

A major issue is whether the central bank’s own liquidity injections – for example via bond purchases – or actual demand from banks at auctions should determine the availability of cash and, consequently, short-term interest rates.

ECB board member Isabel Schnabel, who is in charge of market operations, earlier this year appeared to advocate a system used by the Bank of England, which allows banks themselves to determine the amount of liquidity they want to hold.

Such a “demand driven floor-system” would let the ECB add excess liquidity as needed as opposed to running a permanently oversized balance sheet.