30 March 2012

Christian Thimann: ECB inflation-fighting powers remain intact

A recent VoxEU column argued that with the three-year liquidity operations, the ECB has "hit a limit in its ability to prevent an acceleration of inflation". This column explains why the ECB's inflation-fighting powers remain intact – and why the risks of a sudden inflationary spike remain low.

Tornell and Westermann’s main argument (view column) is that the ECB would not be effective in raising interest rates because short-term lending to banks is currently very limited in view of the large long-term operations outstanding. Therefore, an interest rate increase would not be very effective. They also argue that raising minimum reserve requirements might put some banks under strain; that asset sales would have undesirable implications in financial markets; and that raising the deposit rate paid to banks would risk imposing losses on the central bank.

This analysis overlooks four points that together suggest that the ECB has by no means reached a limit in its ability to fight inflation despite the large volume of outstanding three-year operations, and that the risks of a sudden spike in (core) inflation are actually very limited.

1. The first and most important point to add to Tornell and Westermann’s analysis is that the interest rate on the three-year operations is not fixed at 1 per cent. Rather, it is indexed to the main ECB policy rate, that is, the rate on the main refinancing operations.  If this rate were to rise, the costs for the remaining period of the three-year LTROs would also rise.
2. The second point is that changing the main refinancing rate is not the only tool that the ECB would have to deal with outstanding liquidity. It could raise all of its policy rates including in particular the rate on its overnight deposit facility, currently at 0.25 per cent. Contrary to what Tornell and Westermann suggest, the ECB would make no losses from such an increase because the deposit rate would in no case exceed the rate on the liquidity providing operations. It would make lower profits, but profit-generation is not an objective of the ECB. As a consequence of a higher rate on the deposit facility, the inter-bank market rate – the so-called Eonia rate, currently at around 0.35 per cent – would, of course, also rise because banks would not lend to other banks at lower rates than they can get from the ECB. Further instruments are also conceivable. The ECB could tender longer-term deposits if it wanted to lock-in the liquidity at longer maturities. And it could activate the issuance of debt certificates, which are an instrument foreseen in its monetary policy operational framework.
3. The third point when discussing potential risks of inflation is that it is not the balance sheet of the central bank but the balance sheets of commercial banks that are relevant because the latter show the interactions with the real economy. The former only shows that the central bank is currently replacing the intermediation function owing to the malfunctioning interbank market. Of the roughly €1.2 trillion provided to commercial banks in liquidity-providing operations (of which about €1.1 trillion is over three years), roughly €750 billion is still on the ECB’s deposit facility and about €100 billion is blocked as required reserves held with the central bank. The remainder, about €350 billion, is to cover other structural elements of liquidity demand, such as banknotes.
4. Inflation expectations both over the medium and longer term remain well anchored. The expected average annual inflation rate derived from financial markets for the next five years stands currently at 1.7 per cent. The five-year five-year forward – the five-year inflation rate expected for five to ten years – currently stands at 2.2 per cent. 

In conclusion, these points suggest that all interest-rate tools and tools of liquidity-absorbing operations remain effective, also in view of the special outstanding operations. Therefore, should potential inflationary pressures arise, the ECB Governing Council has all the tools available to counter them.

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