Quantitative ECB policy continues after the end of QE
Unless the economic climate deteriorates sharply in the coming months, the European Central Bank (ECB) will end its monthly Asset Purchase Programme (APP) of mainly government bonds by the end of 2018. By doing so, liquidity injections of 15 billion EUR per month will come to an end. In the next phase, financial markets’ attention will largely be focused on the ECB’s future interest rate policy. However, even after the likely termination of its purchase programme, the ECB will still use other quantitative policy tools. Longer-term refinancing operations, in combination with a persistent policy of full allotment, will ensure abundant liquidity provision in the euro area.
Adressing the crisis in three steps
The ECB, like the Fed and the Bank of England, initially reacted to the financial crisis and to the Great Recession by lowering its policy rate towards zero percent. In 2014, its effective policy rate eventually even became negative.
As soon as it became clear that a zero interest rate policy was insuffient to ease the European deflation fears, the ECB turned to a wide range of non-conventional policy tools. In a first stage, the central bank held refinancing operations with a longer-than-usual maturity. Whereas the main refinancing operations (MROs) have a maturity of one week, longer-term refinancing operations (LTROs) with maturities of three months (and some even significantly longer) were introduced.
Refinancing operations as a policy tool, however, do have one significant disadvantage for the ECB. In order for the policy to be effective, the central bank depends on the willingness of the participating banks to continue to make sufficient use of the offered liquidity.
To deal with this issue, among other factors, the ECB started its purchase prorgamme of mainly government bonds in 2015. That programme came on top of the already existing prurchase programmes of private sector financial assets. All programmes taken together constitute the Asset Purchase Programme (APP). As shown in figure 1, APP significantly contributed to the doubling of the Eurosystem’s balance sheet since the start of the financial crisis.
Figure 1 - Eurosystem balance sheet doubled since financial crisis (consolidated data, end of year, in million EUR)
Quantitative policy far from over
After deflation fears receded and the European economy was in a relatively good shape, the ECB decide in July 2018 to scale down its purchase programme. Unless the economic outlook deteriorates unexpectedly, the ECB will fully end the programme by the end of 2018. A first policy rate hike is unlikely to happen before the end of the Summer of 2019.
With the end of APP in sight, it looks as if the era of quantitative monetary policy is also coming to an end. At first sight, the ECB’s monetary policy appears to be gradually returning to more traditional interest rate policy. This is, however, only part of the picture. For example, the ECB has so far no intention to scale down its inflated balance sheet in the near future. Assets on the ECB’s balance sheet reaching maturity are reinvested. In other words, the liquidity that was created to make the initial purchase remains in circulation and contributes to a persistent accommodative monetary environment. This accomodative policy stance will continue to support European economic growth. At the same time, by keeping interest rates low, it also supports public debt sustainability in the euro area. The downside of the latter is that it may reduce the incentive for some European governments to put the consolidation of their public finances higher on their political agenda.
‘As much as you want’
Moreover, an important feature of the current ECB policy is not receiving the public attention it deserves. Since the financial crisis, the ECB has been using the procedure of full allotment of liquidity. In other words, during its regular refinancing operations, the ECB is allocating all the liquidity that is requested. The only condition is that the specific financial institution is solvent and provides sufficient collateral. Before October 2008, the procedure was different. The ECB determined the amount of liquidity it wanted to inject into the market and allocated this through an auction.
The ECB intends to maintain this crisis policy of full allotment for as long as necessary, and at least until the end of 2019. The attractive combination of virtually unlimited liquidity provision and the availability of LTROs, has almost fully reduced the significance of the traditional refinancing operations (figure 2). This will probably remain the case, since we do not expect any change of the ECB’s policy in this matter in the short term.
Figure 2 - Short term refinancing operations have become marginal (in percent of total liquidity provision by the ECB)
Temporary measures become permanent
The full allotment policy was introduced as a crisis measure to address liquidity problems during the financial crisis. Ten years later, it is still in place.
Explicit asset purchase or sale programmes will remain a central part of the monetary policy toolkit of the ECB. It looks as if the same is true for the allocation procedure of the ECB’s refinancing operations. Therefore, the likely end of APP at the end of 2018 by no means implies the end of non-conventional monetary policy as such.