The European Central Bank’s timid operational framework update

Much ado about nothing. The Shakespearean expression conveys the message that great expectations often presage disappointment. This applies well to the European Central Bank’s review of its monetary policy operational framework – the set of tools through which the ECB transforms words into market facts. The review was announced in December 2022, but when published finally by the ECB Governing Council on 13 March left more issues undecided than concluded. ECB executive board member Isabel Schnabel on 14 March clarified many analytical points but could obviously not go beyond the substantive decisions taken by the Governing Council.

The review gives no indication of the desired amount of excess liquidity to be left in the system, nor any indication of the parameters for establishing the desired amount. No information is given about the conditions applying to the ECB’s new longer-term lending facilities – for instance their maturity or whether variable or fixed rates will apply. Similarly, no indication is given about the duration, composition and size of the so-called structural portfolio of securities that the ECB will hold for monetary policy purposes.

The timing for the introduction of the new longer-term lending facilities and of the portfolio of securities is, somewhat oddly, given as “once the Eurosystem balance sheet begins to grow durably again,” as if the growth of the balance sheet was an exogenous fact and not a critical variable the ECB should decide on. Indeed, the timing of the introduction of the structural facilities and the portfolio of securities is crucial to avoid instability of the market overnight rate when excess liquidity reduces.

Another issue that the review should have looked at is the possible access of non-bank financial institutions to central bank lending or deposit facilities. Non-bank financial institutions have greatly increased their share of intermediation in the euro area but have no direct interaction with the central bank. Other central banks, such as the Fed and the Sveriges Riksbank, have allowed some kind of access or are considering it.

Yet another issue one could have hoped to see in the review is the potential effect of the introduction of a central bank digital currency – the digital euro – on bank liquidity and thus on the provision of liquidity from the ECB. Curiosity on this point will have to wait longer until the two dossiers – the digital euro and the operational framework – are jointly considered.

About 10% of the ECB statement is devoted to explaining what has not been decided so far and when it will be decided: the Governing Council will monitor future developments and review the key parameters of the framework in 2026 and will carry out an “in-depth analysis of the design of the design of the new longer-term refinancing operations and the new structural portfolio”.

The one clear innovation is the narrowing to 15 basis points of the spread between the main refinancing operations (MRO) rate and the rate applied to the deposit facility. The former allows banks to borrow from the ECB via its weekly operations; the latter should be the main policy rate of the ECB. But this step, to be implemented in September 2024, will likely be irrelevant for some time, until excess liquidity ceases to be so abundant that some banks, unlike now, need to start borrowing from the MRO.

The best that can be said is that the narrowing of the spread is an insurance policy coming into effect when, because of much lower excess liquidity, the market overnight rate moves away from the deposit facility rate. The effectiveness of this insurance policy remains to be seen: if there was stigma in borrowing from the MRO, because this could indicate inability to borrow from the market, the market rate would not stop at the MRO rate.

In a way it is good that so little is decided and so much is left to the future. Currently, there is not enough information – for instance about liquidity demand from banks or the future distribution of liquidity across the euro area – to delineate more precisely the operational framework that should prevail in the steady state. The ECB would have risked taking the wrong decisions if it had been more precise and complete. The 14 months between the announcement of the review and its publication seem excessive considering the review amounts to just five pages, but if the conciseness derives from an awareness that it would have been imprudent to write more, it is to be applauded. And, given the evidence so far that quantitative tightening (ie changes in the bank’s balance sheet) has little impact on inflation, there was no urgency to do the review now rather than when more information becomes available.

In conclusion, it is good that the ECB under-delivered after having overpromised; more radical change would have brought risks.