At his penultimate press conference before his term ends next month, European Central Bank (ECB) President Mario Draghi delivered the package of monetary policy easing measures he had skilfully telegraphed during previous months. That fiscal policy is becoming the new monetary policy when it comes to fighting recession was a key conclusion of PIMCO’s Secular Forum, and this was the message President Draghi underlined through both actions and words.
“The answer is fiscal policy.”
– Mario Draghi, 12 September 2019
While the ECB cut its deposit facility rate by 10 basis points and continues to indicate this rate could go lower, on balance the package of measures was tilted more toward quantitative easing (QE) – and therefore toward supporting fiscal policy – and less toward using up what little remains of interest rate policy. The ECB will resume net asset purchases at a rate of €20 billion per month “for as long as necessary to reinforce the accommodative impact of its policy rates,” and with the intent of ending them “shortly before it starts raising the key ECB interest rates” in the future. State-dependent forward guidance, a staff forecast for only 1.5% inflation by 2021, the forthcoming review of the monetary framework under new ECB President Christine Lagarde, and the likely absence of a meaningful expansion of fiscal policy over coming years all imply it could take a very, very long time before the ECB reaches the point of being able to raise rates. Through its actions, therefore, the ECB is signalling to fiscal policymakers that interest rate policy has reached its limits, but asset purchases will be there to support fiscal policy for as long as necessary.
Devil in the details
The ECB will apply a two-tier system to the rate of interest applying to excess reserves from 30 October onward. This should benefit banks in countries with high levels of excess reserves while it could cause unintended consequences for banks in countries with few excess reserves.
Up to now the ECB has remunerated required reserves at the 0% rate applying to the main financing operations and excess reserves at the rate applying to the deposit facility, now −0.5%. Going forward, the ECB will continue to remunerate required reserves at 0%; however, it will remunerate excess reserves held on banks’ current accounts up to a multiple of six times required reserves at 0%, while reserves above that threshold will continue to be charged the deposit facility rate. Currently, average required reserves are €131 billion and excess reserves €1.8 trillion. A six times multiple of required reserves means €788 billion will now be remunerated at the subsidised 0% exemption rate, leaving approximately €1 trillion of excess reserves remunerated at −0.5%. This has three implications.
- First, the residual amount of reserves still attracting −0.5% is more than sufficient to ensure the unsecured overnight rate trades close to the deposit facility rate. An exemption multiplier larger than 10 times required reserves would likely have caused overnight rates to drift higher.
- Second, reserves exempted from the punitive deposit facility rate amount to a quasi-fiscal transfer that will tend to accrue to the benefit of banks in countries with high excess reserves, like Germany and France, who benefit directly from the subsidy.
- Third, the exemption applying to excess reserves introduces a new 0% yielding asset. Banks in countries with insufficient excess reserves to fully utilise their new tiering quota will be incentivised to engage in transactions in order to acquire new reserves to deposit at the ECB at 0%. This could put upward pressure on negative yielding money market instruments in those regional markets, such as Italy, where there is a shortfall of excess reserves relative to the new quota of exempted reserves yielding 0%. This is an example of Thiers’ Law, named after French statesman Adolphe Thiers, whereby good money drives out bad money. This effect, together with the realisation that while tiering the rate applying to excess reserves helps mitigate some of the side effects of negative interest rates, it does not facilitate endless interest rate cuts, has led the market to revise upward its previous lofty expectations for the effective lower bound of ECB policy rates.
Will it work?
For financial markets, we believe the package will first and foremost suppress volatility. We would expect levels of volatility on European financial instruments to gradually converge toward the lower volatility observed in Japan. The package should also support credit and, indirectly through the demand for income, other sectors such as high yield and emerging market bonds.
Concerning inflation, however, we are less optimistic. The ECB is doing what it can; however, a poll conducted by Thomson Reuters before this week’s meeting found that 82% of respondents were not confident the ECB would be able to influence inflation significantly over the next two to three years. We concur. The eurozone is experiencing a lack of aggregate demand relative to supply. Today’s monetary policy decisions will help spur demand, but fiscal policy (such as government stimulus packages) could have a more direct and larger effect. We think negative nominal interest rates are detrimental on balance, owing to the so-called money illusion effect (in which investors view money and income in nominal, not real, terms) and the risks they entail for financial stability. Although irrational, negative nominal rates crystalise savers’ loss of purchasing power, creating incentives to save more and take more investment risk as well as reinforcing low inflation expectations. That long-term inflation expectations derived from financial markets remain well below the ECB’s inflation target, even after today’s policy changes, testifies to Europe’s Japanification risks.
Learn about key secular disruptions likely to affect the outlook for the eurozone.
Andrew Bosomworth is PIMCO’s head of portfolio management in Germany and a regular contributor to the PIMCO Blog.