In 1889, a brilliant young mathematician named Henri Poincaré was awarded a prize established by the Swedish King Oscar II for solving the infamous three-body problem. A solution for predicting the movements and positions of two bodies was known for ages; however, a solution to the more realistic three-body problem proved to be elusive. Later on, Poincaré found a mistake in his work. His solution was all wrong. It turns out that predicting the exact position of three bodies interacting with each other is impossible. Even though simple rules might govern each body’s behaviour, the result of their interaction is unpredictable. Through this fortunate mistake, a new field of mathematics was born: chaos theory.
Monetary policy has always worked within the domain of chaos, but the complexity of monetary policy has increased substantially in recent years—and the pandemic has accelerated the need for innovations. Central banks used to simply target interest rates and tend to daily liquidity issues via open-market operations. They also set reserve requirements, but this tool’s relevance has dwindled due to the financial system’s changing structure.
After the global financial crisis (GFC), monetary easing was central, but interest rates rather quickly hit the effective lower bound, and the European Central Bank (ECB) had to innovate. Open-market operations became one-directional and morphed into continued asset purchases. To improve the monetary-policy transition mechanism and ensure financial stability, the ECB recognised that the short-term provision of liquidity might not be sufficient, so they introduced targeted longer-term refinancing operations (TLTROs). Once the pandemic struck, the ECB started offering longer-term financing at a lower price than their policy rates—in effect, moving to a dual-rate policy regime.
How do the different tools affect market rates?
The evolving tool kits of central banks broaden the range of possibilities. Monetary policy works through dozens of channels, but at first, it affects short-term market interest rates. However, the ability to tune individual instruments makes it difficult to assess the net effect, even on them.
Policy rates serve as an anchor to all other market rates; it is a starting point from which all other market interest rates are derived. Currently, due to massive excess liquidity in the euro area, the deposit facility is acting as the main policy rate.
Asset-purchase programmes—or quantitative easing (QE)—are often simplified to “money printing”. What actually is happening is liquidity transformation. The central bank exchanges fewer liquid bonds into central-bank reserves. The increased demand for bonds directly pushes down on bond rates, but it also spills over into money-market rates. A side effect of QE is the generation of excess reserves (reserves above the minimum reserve requirement). The stock of deposits grows faster in relation to the stock of loans, resulting in excess reserves in the banking system. Because of QE, short-term rates are no longer anchored to the main refinancing rate but the deposit facility.
Money created via quantitative easing has a big problem—it has a very limited possibility of escaping into the real economy. QE creates reserves that are essentially trapped in financial markets; it increases the supply of money in the real economy very little. QE affects the real economy mostly indirectly through wealth, foreign exchange and portfolio-reallocation channels. This is the primary reason why the previous decade’s fears of hyperinflation were unfounded. Money supply in the real economy increases when private sectors and governments borrow to finance goods and investments, which they finally started to do in 2020.
Now that fiscal policy is more active, QE is more effective. QE enables cheap government borrowing, making fiscal policy both more effective and more sustainable. But it is also a slippery slope: the so-called monetary financing of deficits is a powerful way to inject money into the real economy. But if overdone, it can lead to overheating and inflation. When economies are significantly below their potential, the risks are small. But the policy must be managed carefully and withdrawn once economies are back on track. Alas, this will be hard to do—bloated government debt in many euro area countries means that increases in interest rates or scale-backs of asset purchases may heavily strain public finances. Therefore, the ECB will probably have to stick to lower rates and asset purchases for longer than it would like.
Because the power to inject money into the real economy lies in the process of credit creation, the TLTRO instrument was created. At first, it was simply a tool to provide stable, longer-term liquidity to the banking sector to ensure financial stability. Later, the tool was modified: the ECB started offering even lower rates if banks met their quotas on lending to the real economy. In theory, this should both push down borrowing costs and incentivise looser credit standards, resulting in faster credit growth and higher aggregate demand. Additionally, banks could then offer better rates to the private sector, leading to increased credit demand.
In times of financial stress, it is important to maintain the supply of credit to the real economy. So, when the pandemic hit, the ECB offered banks a sweet deal: continue lending to private business, and they could borrow from the central bank at up to -1 percent (the deposit facility rate minus 50 basis points). The main idea of such an offering was to create a powerful incentive for private banks to continue lending to the real economy and avoid a credit crunch, which is common during crises. In practice, the ECB is now operating under a dual-rate regime. Deposit rates in the euro area are benchmarked to the deposit facility rate because it reflects what it would cost to park an additional euro at the ECB. But lending rates to non-financial corporations theoretically ought to be benchmarked to the TLTRO rates.
However, the transmission mechanism is not so simple. While the ECB’s offer was successful, the transmission of TLTRO rates to lending rates (and the increase in credit supply in general) could prove inefficient and slow. Banks could be slow to adjust their pricing if there is uncertainty about the offering’s duration, which could lead to a maturity-mismatch risk. Also, some banks could be constrained by capital requirements and unable to expand their balance sheets enough to benefit from the favourable offering.
Despite the uncertainty and shortcomings, the demand for the latest rounds of TLTRO funding has been high. The injection of super-cheap funds has coincided with elevated market stress and higher credit-risk premiums. It is difficult to assess the impact of TLTRO on the cost of liquidity. But the fact that most short-term market rates sit below the deposit facility rate suggests that it was at least partially successful in pushing down the weighted marginal cost of liquidity.
Each of the ECB’s three principal tools—policy rates, QE and TLTRO—theoretically has a distinct purpose, but their effects are intertwined. Tweaking one policy inescapably has consequences on the other tools’ effectiveness, and these consequences can be hard to predict. Probably this is why Christine Lagarde, the ECB’s president, emphasises the need to look at the complete toolset so much because focusing on individual instruments is misleading.
The primary goal of the ECB is price stability, but European price dynamics do not live in a vacuum. The ECB has important secondary considerations when setting policy. Often, these secondary factors try to pull monetary policy in different directions. The more frugal parts of Europe have been grumbling about the hyper-loose monetary policy for quite some time. A significant part of the population depends on interest income to finance its retirement, and the low-interest-rate environment certainly hurts its savings prospects. True, low-interest rates have boosted equity prices and household wealth, but the valuations in some cases (mostly in the United States) look extremely stretched; share prices have risen so much only because of the lack of better alternatives and the hunt for yields. This kind of wealth is probably neither desirable nor sustainable. Also, there is rising concern about wealth and income inequality induced by loose monetary policy. The pandemic has silenced these voices of discontent, but it is only a question of time before they reappear.
On the other hand, many European countries have a debt problem. The austerity experiment showed that it is very difficult to solve this problem by saving. The paradox of thrift kicks in, and the problem remains. One way of dealing with debt overhang is financial repression (keeping interest rates below economic growth rates); that’s how countries dealt with post-World War II debt. However, solving the debt problem is at odds with savers’ interests and, potentially, price-stability goals. Balancing these competing interests will be a challenge for the ECB down the road. Likely, monetary policy will not be able to resolve these issues on its own.
TLTROs and dual rates are likely to become permanent instruments
The dual-rate system has a lot of potential to become much more significant. If the ECB establishes it as a strong permanent tool, it can be both a way around the effective lower bound and a way out of negative deposit rates. Theoretically, if the volumes of liquidity provided via the TLTRO programme are significant enough, it could be the channel to enact significant monetary easing without risking bank disintermediation in the future. Negative rates applied with this instrument would still carry most risks to financial stability that arise from loose monetary policy. A prolonged loose policy incentivises stretched asset valuation, excess risk-taking and overleverage, all of which can cause financial stress down the line. However, the conditions attached to the TLTROs could be used to manage stability risks and side effects.
Theoretically, a combination of deposit and TLTRO rates should be possible to allow both the deposit rate to return to zero and maintain the average cost of liquidity at current levels. In short, the ECB could move the TLTRO and deposit rates in opposite directions so that their weighted average would stay the same. In practice, though, this would be difficult to pull off. The ECB cannot fully control excess-reserves levels, and it controls the stocks of TLTRO loans even less.
The establishment of TLTROs as a third significant instrument in the toolbox certainly broadens the possibilities of monetary policy. Theoretically, this should allow the ECB to finetune the degree of monetary accommodation, address bottlenecks and alleviate some negative side effects of the other policies. However, the increased complexity has risks. The three instruments might interact with each other in unpredicted ways. For example, they could alter the behaviour of market participants or create unexpected feedback loops. With a greater range of possibilities, there is also more room for potential error. In addition, a bigger toolkit could make it harder for market participants to form expectations about the future path of interest rates. This could lead to much higher volatility and potential distress.
Overall, as traditional monetary instruments have reached their limits, the ECB has responded by innovating to expand its instruments. TLTROs are probably among the most underappreciated tools at its disposal, as they can stimulate the real economy more directly. This added flexibility will be put to use, as the challenges for monetary policy in Europe will be immense in the years to come. However, the increasing complexity of monetary tools not only expands the frontier of possibilities but also brings in a degree of unpredictability or—some might even say—a little chaos.