Draghi’s historic farewell

Eric Lonerga Helicopter MoneyMonetary PolicyMoney in Europe6

This week’s policy decision by ECB is historic. For some time now, a number of economists have suggested that dual interest rates are the logical next step in the arsenal of central banks.[1] Dual interest rates refers to a policy where central banks independently target the rates at which they lend to banks and the rates at which they remunerate deposits at in order to stimulate demand. Dual interest rates always work. If lending rates fall below deposit rates the central bank is transferring money to the private sector. If access to this transfer is linked to extending loans, such as under the ECB’s TLTRO, the power is amplified.

Several months ago, I suggested that the ECB raise the deposit rate, which they pay on bank reserves to zero, and that they slash the interest rate on TLTROs to a fixed -1% for up to ten years. On reflection, and after exchanges with a number of policy-focused economists on Twitter[2], I am reasonably convinced that they have in fact done something very similar to this. In this era of central bank obfuscation, it has taken several days of reflection and calculation, to work this out. The net result of this barrage of measures, however, is in fact to raise the interest rate on the interest paid on bank reserves in the Eurozone, while cutting the ECB’s ‘lending rate’ – the interest rate on TLTROs. (See technical note below for calculations.)

Specifically, the ECB has moved to a zero interest rate on excess reserves up to 6x required reserves. Banks with excess reserves below this level can now borrow reserves at negative rates and deposit with ECB, generating positive carry. Furthermore, using TLTROs banks will be able to borrow from the ECB itself at -0.5% under certain conditions and earn positive carry if these transactions result in them holding higher excess reserves, but less than 6x required reserves. The distributional consequences between northern and southern Europe are not completely clear, but my initial thoughts are that it creates an incentive for banks in Northern Europe holding reserves in excess of 6x their required holdings to effectively lend these reserves to banks in Southern Europe.

On reflection it is astonishing this has been approved. TLTROs and tiered reserves are a far more significant monetary innovation than QE. Macro policy econs need to wake up on this. If legal, the limits to monetary policy have just been lifted.

The critical psychological breach is a central bank engaging in a marginal increase in reserves which under certain conditions will generate negative net interest margin to the central bank. Official interest rates are now having the net effect of transfers to private sector.

Be in no doubt. Dual rates is monetary rocket-fuel. In contrast to standard negative rates, to forward guidance, or QE, the marginal effects of these policies are increasingly powerful. I am not convinced that this specific combination of measures will suffice to generate enough demand to create an acceleration in Eurozone activity – but it will help. But further move along these lines will have increasingly impact. For example, cutting the TLTRO rate further and paying zero interest on a larger share of reserves, would have an even greater effect.

There is little doubt, that the ECB under Mario Draghi, has been a source of hugely clever innovation, and deft political skill. Obfuscation may be the inevitable price we have to pay. The populists on the polar extremes of this argument, have so far been too lazy or too dumb to work it out.
Hats off to Draghi. He parted with a dismissal of ‘monetary innovation’ having just landed one of the most significant innovations monetary history. Media coverage to date appears oblivious to the significance.

Technical note
the ECB now has three tiers of reserves: 1) Minimum or required reserves (MRR); 2) excess reserves which are a multiple of the MMR (currently 6x), remunerated at zero percent; and 3) additional excess reserves, which pay the deposit rate, which is currently -0.5%. According to ECB data, there are €1.2trn on excess reserves, and the average reserve requirement is €132bn. On my understanding, up to €900bn is on zero percent interest rates. The remaining €435bn is paying -0.5%, ie €2.2bn, or an average interest rate of -16bps on all reserves. By contrast, the best rate that can now be received on a TLTRO is -0.5%. Prior to these changes, the banking system was paying 0.4% on €1.2trn of reserves, or €4.8bn, or -35bps on average. The net effect therefore is to have reduced the negative rate on bank reserves in aggregate and cut the rate at which banks can receive funding under TLTROs. The ECB has just moved the dual rates in opposite directions.


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