Did ECB Accidentally Tighten Policy? Analysts Won’t Let it Drop

(Bloomberg) -- Almost two weeks after the European Central Bank announced new stimulus measures, economists are still debating whether the plan will work the way it’s meant to.

Their chief concern is the central bank’s so-called tiering system. While it’s designed to ease the burden of negative interest rates on banks, some analysts fear it may inadvertently tighten monetary policy at the same time.

It won’t become clear until later in the year whether the doubts are warranted, but everyone’s talking about it now -- from banks and investment firms to the ECB’s own Money Market Contact Group. A surprisingly low take-up of cheap long-term loans last week added fuel to the discussion.

“Tiering may be having some unwelcome impact,” Gilles Moec, chief economist at AXA SA in London, wrote in a note this week. “It seems ‘mitigating the impact of negative rates’ without affecting the transmission of monetary policy is not working very well.”

The argument revolves around the ECB’s deposit rate, which it cut to a record-low minus 0.5% on Sept. 12 as part of the effort to revive inflation. In theory, that should bring down all borrowing costs, making investment and consumption cheaper and so helping to boost the economy.

But at the same time the ECB granted lenders an exemption from negative rates for a portion, or tier, of the cash they hold -- which amounts to as much as six times their minimum reserves. It means about 40% of current excess liquidity in the financial system may be freed from the sub-zero policy, lifting the average deposit rate paid by banks.

The two-tier system will first be applied in the six-week period starting Oct. 30, and the risk for policy makers is that Eonia -- the Euro Overnight Index Average -- starts to settle nearer the new weighted-average deposit rate for banks, rather than around the lower headline rate.

While daily fixings have so far fallen in line with the adjustment to the deposit rate, a sign of this longer-term uncertainty is already being played out in markets, where three-month Eonia forwards have climbed to a six-week high.

TLTRO Blow

Adding to concern over the ECB’s latest easing measures, just 28 institutions took up an offer of free cash in its most recent longer-term refinancing operation, or TLTRO. That compares with hundreds of bidders at previous operations. And they took a total of only 3.4 billion euros ($3.8 billion), far below analyst estimates for up to 100 billion euros.

It may be because banks didn’t have enough time to adjust plans after the ECB’s latest policy decisions, and because they’re waiting for tiering to kick in before tapping future TLTRO opportunities. But it’s unhelpful for a central bank trying to fed off recession risks at a time when investors are questioning the effectiveness of monetary policy.

What we are seeing right now “doesn’t exactly look like a vote of confidence in the ECB’s ability to control market rates,” said Rishi Mishra, an analyst at Futures First. “But there are a plethora of misconceptions floating about the measures announced in the market.”

The ECB maintains that the interest rate in the overnight interbank market will gravitate toward the rate on the deposit facility. That’s because the latter will represent the marginal rate for bank reserves, according to a spokesperson, who cited the experiences of Switzerland and Japan.

The use of tiering in those nations shows markets have tended to settle near the central bank rate, rather than the weighted average -- a point made by the ECB spokesperson. It’s a policy that’s long been applied in Switzerland, where the deposit rate is at minus 0.75%, even though the Swiss National Bank imposes no charge on amounts up to 20 times banks’ minimum reserves -- and it’s going to increase that to 25 from November.

Currency Bloc

But a tiering system hasn’t been tested in a multi-country currency area like the euro zone, where banks in Germany are flush with excess liquidity, while their Italian counterparts may not fully benefit from the exemption.

“ECB tiering needs work, or core term premia will collapse -- which is my polite way of saying that ECB made a boo-boo,” said Peter Chatwell, head of European rates strategy at Mizuho International Plc. “This incentivizes banks to put more cash on deposit at the ECB at 0%, rather than putting it to work.”

If the ECB can’t get traction with its stimulus measures, President Mario Draghi or his successor from Nov. 1, Christine Lagarde, may have to rethink their strategy. The good news is that the Governing Council has already signaled the multiplier of six times reserves could be adjusted if needed to control the deposit rate.

Chief economist Philip Lane said last week that tiering has been calibrated to strike the right balance between offsetting the cost of negative rates for banks while still allowing the accommodative policy stance to filter through and boost inflation. But he also opened the door to changes if the market impact isn’t as intended. ECB Vice-President Luis de Guindos told the central bank’s money market contact group in Frankfurt on Tuesday that policy makers see “very little evidence” of upward pressure on money market rates.

Bond markets seem unconvinced that the ECB’s measures will fulfill their purpose. Two-year yields in Germany jumped the most since 2015 in the aftermath of the policy decision and remain above previous levels, while Italian bonds declined after the low take-up of cheap loans.

“The ECB just hiked rates,” said Arne Lohmann Rasmussen, head of fixed-income research at Danske Bank A/S in London. “The tiering program is much bigger than the market thought.”

--With assistance from Tanvir Sandhu.

To contact the reporters on this story: John Ainger in London at jainger@bloomberg.net;Piotr Skolimowski in Frankfurt at pskolimowski@bloomberg.net;Yuko Takeo in Tokyo at ytakeo2@bloomberg.net

To contact the editors responsible for this story: Paul Dobson at pdobson2@bloomberg.net, Paul Gordon

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