ECB's Quest for Tighter Policy May Face Challenge From Ester

(Bloomberg) -- The European Central Bank’s bid to wean itself away from ultra-loose monetary policy may be challenged by an unlikely development: the creation of a new overnight borrowing rate.

Ester, which the ECB will publish by October next year, will eventually replace Eonia as the risk-free rate. However, unlike Eonia that is still anchored by the deposit facility, the Ester rate includes a range of wholesale counterparties that don’t have access to it. That could mean fixes below the ECB’s benchmark rate, complicating the exit from years of record-low interest rates, said Bank of America Merrill Lynch.

“The problem is that the majority of short-end reference rates in the euro area have completely detached from the ECB’s key interest rates,” Ruairi Hourihane, European rates strategist, wrote in a note to clients. “Ultimately the ECB is concerned that as rates are raised, money-market rates will no longer align with or convey the central bank’s tighter policy stance.”

The ECB has said it won’t increase interest rates until through the summer of next year, with money-market pricing -- derived from the Eonia rate -- showing expectations for a 10-basis-point hike in September. ECB Executive Board member Benoit Coeure has previously warned that “a continued dispersion of short-term rates would adversely impact the transmission of our monetary policy stance.”

Borrowing Rate

BofAML highlighted the experience of the U.S., where three Federal Reserve hikes in 2016 and 2017 failed to tighten financial conditions as a reason to be concerned. The ECB, it said, could either adopt a Fed-style reverse repurchase agreement, whereby it would broaden out access to its balance sheet to non-banks; increase the 75 billion euros ($87 billion) of bonds currently lent versus cash collateral; or reduce the cost of securities lending versus cash.

The average level for the Ester rate has been estimated to be around nine basis points lower than the Eonia fix and five basis points below the deposit rate because of the simple transition from a “lending rate” to a “borrowing rate”.

This raises questions about “how much Ester will reflect the policy rates and corridor moves,” wrote Morgan Stanley strategists Elaine Lin and Robert Brown. “This will add to the uncertainty over how the effective policy rate will move.”

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