{"id":59736,"date":"2012-03-30T10:38:40","date_gmt":"2012-03-29T23:38:40","guid":{"rendered":"http:\/\/www.fnarena.com\/index.php\/2012\/03\/30\/has-the-ecb-hit-a-limit\/"},"modified":"2012-03-30T10:38:40","modified_gmt":"2012-03-29T23:38:40","slug":"has-the-ecb-hit-a-limit","status":"publish","type":"post","link":"https:\/\/staging.fnarena.com\/index.php\/2012\/03\/30\/has-the-ecb-hit-a-limit\/","title":{"rendered":"Has The ECB Hit A Limit?"},"content":{"rendered":"<p>\n\tBy Aaron <span>Tornell<\/span> and Frank <span>Westermann<\/span><\/p>\n<p>\n\t<em>&ldquo;Should the inflation outlook worsen, we would immediately take preventive steps&rdquo;. So said Mario <span>Draghi<\/span>, President of the European Central Bank. This column argues that these are brave words given that the <span>ECB<\/span> has hit a limit in its ability to prevent an acceleration of inflation.<\/em><\/p>\n<p>\n\tIn December, the <span>ECB<\/span> successfully forestalled a financial crisis by stepping in with a big bazooka and inundating the market with liquidity. Unfortunately, the big bazooka has come at a cost; the composition of the <span>ECB&rsquo;s<\/span> balance sheet has changed dramatically.<\/p>\n<p>\n\tUnder standard monetary policy, when there is a sudden increase in money growth, the central bank can increase its short-term interest rate and thereby reduce its short-term loans to banks. This policy causes a reduction of bank lending to households and firms, which absorbs excess liquidity and prevents an acceleration of inflation. The <span>ECB<\/span> has lost its ability to implement this type of anti inflationary policy.<\/p>\n<p>\n\tAs seen in Figure 1, the short-term deposits of banks at the <span>ECB<\/span> in excess of the minimum requirements &ndash; the so-called excess reserves &ndash; have experienced an unprecedented increase: from &euro;199 billion in September 2011 to &euro;792 billion in March 2012. These short-term excess reserves can be withdrawn by banks in a sudden manner and now represent 26% of the <span>ECB&rsquo;s<\/span> balance sheet.1, 2<\/p>\n<p>\n\t<img decoding=\"async\" alt=\"\" src=\"http:\/\/www.fnarena.com\/ckfinder\/userfiles\/images\/voxeu30-3a.jpg\" style=\"width: 700px;height: 512px\" \/><\/p>\n<p>\n\tIf banks chose to withdraw their deposit or inflation started for any other reason, could the <span>ECB<\/span> follow the standard policy and raise short-term interest rates? No, because this policy instrument is not available to the <span>ECB<\/span> anymore; its short-term lending to banks has practically hit zero. It has collapsed from &euro;201 billion in September to &euro;18 billion in March. Presently, the <span>ECB&rsquo;s<\/span> short-term loans to banks represent only 0.6% of its balance sheet.<\/p>\n<p>\n\tIn principle, the <span>ECB<\/span> could take other actions to absorb an excessive increase in liquidity. It could:<\/p>\n<ul>\n<li>\n\t\tIncrease minimum reserve requirements;<\/li>\n<li>\n\t\tSell assets other than its short-term loans to banks; or<\/li>\n<li>\n\t\tIncrease the interest rate on bank deposits at the <span>ECB<\/span> to discourage banks from making withdrawals.<\/li>\n<\/ul>\n<p>\n\tLet us consider each in turn.<\/p>\n<p>\n\tIs the <span>ECB<\/span> likely to increase the minimum reserve requirements in the foreseeable future? The short answer is no. In fact &ndash; as part of the big bazooka &ndash; the <span>ECB<\/span> reduced the minimum reserve ratio from 2% to 1% on 8 December 2011. As a result, minimum reserves fell by a remarkable &euro;104 billion in February 2012, as shown in Figure 2.3<\/p>\n<p>\n\t<img decoding=\"async\" alt=\"\" src=\"http:\/\/www.fnarena.com\/ckfinder\/userfiles\/images\/voxeu30-3b.jpg\" style=\"width: 700px;height: 455px\" \/><\/p>\n<p>\n\tIn the next few years, the <span>ECB<\/span> will find it exceptionally difficult to increase minimum reserve requirements because there is a sharp asymmetry of excess deposits across countries. While in some countries the excess of deposits over minimum reserves is quite high (<span>eg<\/span> &euro;313 billion in Germany), in other countries there are practically no excess deposits (<span>eg<\/span> &euro;1.5 billion in Italy). Therefore, if the <span>ECB<\/span> were to increase minimum reserves, there might be systemic bank failures among these low excess deposit countries. Since the <span>ECB<\/span> cannot discriminate by increasing minimum reserves for some countries while not for other countries, it will likely keep minimum reserves at low enough levels so that none of the countries risks a liquidity squeeze.4<\/p>\n<p>\n\tCould the <span>ECB<\/span> instead sell other assets in its balance sheet to mop up liquidity? To illustrate why it will not be easy for the <span>ECB<\/span> to do so, let&rsquo;s consider a generous rule which permits the <span>ECB<\/span> to dispose of all its assets at short notice, except those &lsquo;sensitive assets&rsquo; that are clearly difficult to dispose of. As Figure 3 shows, even under our assumed scenario, this upper bound on the share of &lsquo;non-sensitive assets&rsquo; that the <span>ECB<\/span> could sell at short notice has fallen to 26% of the balance sheet. Considering that total excess deposits amount to 34% of the balance sheet, the <span>ECB<\/span> would not have enough non-sensitive assets to sell in order to cover a withdrawal of excess deposits by banks. March 2012 is the first time since the creation of the <span>ECB<\/span> that the upper bound on non-sensitive assets is below excess deposits. Clearly, the <span>ECB<\/span> has hit a critical limit.<\/p>\n<p>\n\t<strong>Figure&nbsp;3<\/strong>.&nbsp;&#039;Non-sensitive&#039; assets&nbsp;vs excess deposits&nbsp;(<span>ECB<\/span>&nbsp;balance sheet shares)<\/p>\n<p>\t<img decoding=\"async\" alt=\"\" src=\"http:\/\/www.fnarena.com\/ckfinder\/userfiles\/images\/voxeu30-3c.jpg\" style=\"width: 700px;height: 536px\" \/><\/p>\n<p>\n\tConsider the list of sensitive assets.<\/p>\n<ul>\n<li>\n\t\tFirst, the <span>ECB<\/span> cannot reduce its stock of &euro;1,100 billion &lsquo;longer-term refinancing operations,&rsquo; which represent 37% of its balance sheet. This was the main component of the big bazooka and matures in 2015.<\/li>\n<li>\n\t\tSecond, the <span>ECB<\/span> cannot easily sell the &lsquo;securities held for monetary policy purposes&rsquo;, which represent 9% of the balance sheet. Despite their name, these securities comprise mainly the government bonds that the <span>ECB<\/span> bought via the Stability Market Program and the Covered Bonds Purchase Program to help banks during the 2008 crisis. If the <span>ECB<\/span> were to sell these securities, longer-term interest rates in crisis countries would increase significantly. Moreover, the <span>ECB<\/span> would experience explicit capital losses.<\/li>\n<li>\n\t\tThird, the <span>ECB<\/span> cannot reduce the Emergency Liquidity Assistance included under the &lsquo;other claims on <span>Eurozone<\/span> credit institutions&rsquo; (2% of the balance sheet).5<\/li>\n<li>\n\t\tFourth, it is unlikely that any of the 17 national central banks that comprise the <span>Eurosystem<\/span> will choose to reduce their holdings of gold (14% of the balance sheet), their international reserves (8% of the balance sheet), their dollar loans to domestic banks or euro-loans to foreign banks (3% of the balance sheet), or their &lsquo;government bonds&rsquo; (1% of the balance sheet). If the fourth option were undertaken, the <span>ECB<\/span> would face the difficult decision of determining which countries should sell assets and which should not.<\/li>\n<\/ul>\n<p>\n\tUnder the generous rule scenario we are considering, the assets that the <span>ECB<\/span> can easily dispose of include &lsquo;other securities&rsquo; (11.7% of the balance sheet), &lsquo;other assets&rsquo; (13.5% of the balance sheet) and the &lsquo;main refinancing operations&rsquo; (the short-term loans to banks depicted in Figure 1, which are 0.6% of the balance sheet). The &lsquo;other securities&rsquo; and &lsquo;other assets&rsquo; categories may or may not contain assets whose price is sensitive to short-notice disposal. The <span>ECB<\/span> is not transparent on the contents of these parts of its balance sheet.6<\/p>\n<p>\n\tThe third option, increasing <span>ECB<\/span> interest rates on bank deposits sufficiently to stem an exodus of withdrawals, does not seem realistic. In fact, excess deposits are typically zero in normal times. Moreover, high enough interest rates on deposits &ndash; without a higher lending rate &ndash; might generate losses at the <span>ECB<\/span>, which is a politically sensitive issue.7<\/p>\n<p>\n\tIn summary, the intersections in Figures 1 and 3 make clear that the <span>ECB<\/span> has lost its ability to implement standard anti-inflationary policies. It is in this sense that <span>Draghi&rsquo;s<\/span> statement is brave. The fact that the <span>ECB<\/span> has hit a limit does not mean that inflation will flare up soon. It does, however, mean that the <span>ECB&rsquo;s<\/span> space to <span>manoeuvre<\/span> has become narrow.8 This lack of maneuvering space will induce an inflationary bias in monetary policy: At the margin, the <span>ECB<\/span> will find it costlier to hit the anti inflationary brakes than to push the monetary accelerator. This bias puts the <span>Eurozone<\/span> at risk of de anchoring long-run inflationary expectations. The danger is not inflation today, but the de-anchoring of expectations about future inflation.<\/p>\n<p>\n\t<br \/>\n\t1 A less conservative number would result if long-term deposits were counted as part of the minimum reserves. Calculated in this manner, excess deposits would now be &euro;1,036 billion or 34.5% of the balance sheet.<br \/>\n\t2 In the recent past, sharp increases in bank excess reserves at the <span>ECB<\/span> have been followed by sudden and sharp reversals, as can be seen in Figure 1. This was the case in 2008 after markets calmed following the bailout announcement; in 2009 after Ireland accepted the bailout; and in 2010 after the <span>1st<\/span> Greek bailout was announced.<br \/>\n\t3 The <span>ECB<\/span> argued that &ldquo;as a consequence of the full allotment policy applied in the <span>ECB&rsquo;s<\/span> main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions.&rdquo;<br \/>\n\t4 Arguably, in the US it would be easier for the FED to respond to a sudden withdrawal of excess reserves by increasing minimum reserves because if some &ndash; small &ndash; banks were to fail, other banks with excess reserves at the FED could take them over. However, in the next few years, such takeovers are not likely in Europe as they would entail cross-border mergers. Therefore, unlike the FED, the <span>ECB<\/span> is unlikely to increase minimum reserves.<br \/>\n\t5 The Emergency Liquidity Assistance (<span>ELAs<\/span>) are unsecured loans given to Greece and Ireland.<br \/>\n\t6 To construct the upper bound on the share of non-sensitive assets that the <span>ECB<\/span> could dispose of at short notice we have made the extreme assumption that all assets included in &lsquo;other securities&rsquo; and &lsquo;other assets&rsquo; could be disposed of at short notice. The true share might in fact be smaller.<br \/>\n\t7 In the future, there might be a fourth possibility. Once the <span>ESM<\/span> is fully operational, the <span>ECB<\/span> could either sell its sensitive assets to the <span>ESM<\/span> or unload them into the market, with the expectation that market participants could then resell them to the <span>ESM<\/span>. In either scenario, the <span>ECB<\/span> might avoid losses, but the taxpayers would not. Essentially, it would be a roundabout capital injection to the <span>ECB<\/span> financed by the taxpayers.<br \/>\n\t8 According to <span>Draghi<\/span>: &ldquo;The banks to which the <span>ECB<\/span> has lent the money have, by and large, not fed this into the economic cycle but have used it to meet old liabilities. So the money in terms of inflation has, so to speak, been neutralized. This action is not inflationary. And we will watch very carefully if and how the money is fed into the economic cycle&rdquo;. A similar statement was made by Peter <span>Praet<\/span>, chief economist at the <span>ECB<\/span>, who added: &ldquo;we have all necessary instruments to counteract&rdquo; inflation if it arrives. The problem is not that inflation has accelerated today, but that the various components of the big bazooka &ndash; the &euro;1 trillion cheap three-year loans to banks, the relaxation of collateral constraints, and the reduction in reserve requirements &ndash; have eliminated several instruments to fight future inflation. <span>Praet&rsquo;s<\/span> statement is in a <span>FAZ<\/span> interview on 25 March.<\/p>\n<p>\n\tDisclaimer: The views expressed are the author&#039;s, not <span>FNArena&#039;s<\/span> (see our disclaimer)&nbsp;<\/p>\n<p>\n\tCopyright VoxEU.org &#8211; the above story was originally published on www.VoxEU.org &#8211; readers reading this story through a third party channel may find that any graphs are not included (our apologies for this technical anomaly) &#8211; here&#039;s a link to the original story on the <span>VoxEU<\/span> website: click <a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/7789\">HERE<\/a><\/p>\n<p>\n\t<strong>Technical limitations<\/strong><\/p>\n<p>\n\t<strong><span style=\"font-style: italic\">If you are reading this story through a third party distribution channel and you cannot see charts included<\/span>, <em>we <span><span>apologise<\/span><\/span>, but technical limitations are to blame.<\/em><\/strong><\/p>\n<p>\n\t<em>Find out why <span>FNArena<\/span> subscribers like the service so much: &quot;<a href=\"http:\/\/www.fnarena.com\/index4.cfm?type=dsp_newsitem&amp;n=29EB960D-9DFF-C00E-7F6B464E5D52E250\">Your Feedback (Thank You)<\/a>&quot; &#8211; Warning this story contains unashamedly positive feedback on the service provided.<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Economists Aaron Tornell and Frank Westermann question whether the ECB has further capacity to act to prevent inflation accelerating.<\/p>\n","protected":false},"author":9,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[5],"tags":[41],"acf":[],"_links":{"self":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts\/59736"}],"collection":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/users\/9"}],"replies":[{"embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/comments?post=59736"}],"version-history":[{"count":0,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts\/59736\/revisions"}],"wp:attachment":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/media?parent=59736"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/categories?post=59736"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/tags?post=59736"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}